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John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
John tracy   the fast forward mba in finance (wiley-2nd ed-2002)
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John tracy the fast forward mba in finance (wiley-2nd ed-2002)

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  • 1. TE AM FL Y
  • 2. 70+ DVD’s FOR SALE & EXCHANGE www.traders-software.com www.forex-warez.comwww.trading-software-collection.comwww.tradestation-download-free.com Contacts andreybbrv@gmail.com andreybbrv@yandex.ru Skype: andreybbrv
  • 3. The Fast ForwardMBA in Finance SECOND EDITION
  • 4. THE FAST FORWARD MBA SERIESThe Fast Forward MBA Series provides time-pressed business profes-sionals and students with concise, one-stop information to help themsolve business problems and make smart, informed business decisions.All of the volumes, written by industry leaders, contain “tough ideasmade easy.” The published books in this series are:The Fast Forward MBA Pocket Reference, Second Edition (0-471-22282-8) by Paul A. ArgentiThe Fast Forward MBA in Selling (0-471-34854-6) by Joy J.D. BaldridgeThe Fast Forward MBA in Financial Planning (0-471-23829-5) by Ed McCarthyThe Fast Forward MBA in Negotiating and Dealmaking (0-471-25698-6) by Roy J. Lewicki and Alexander HiamThe Fast Forward MBA in Project Management (0-471-32546-5) by Eric VerzuhThe Fast Forward MBA in Business Planning for Growth (0-471-34548-2) by Philip WalcoffThe Fast Forward MBA in Business Communication (0-471-32731-X) by Lauren Vicker and Ron HeinThe Fast Forward MBA in Investing (0-471-24661-1) by John WaggonerThe Fast Forward MBA in Hiring (0-471-24212-8) by Max MessmerThe Fast Forward MBA in Technology Management (0-471-23980-1) by Daniel J. PetrozzoThe Fast Forward MBA in Marketing (0-471-16616-2) by Dallas MurphyThe Fast Forward MBA in Business (0-471-14660-9) by Virginia O’Brien
  • 5. The Fast ForwardMBA in Finance SECOND EDITION J O H N A. T R A C Y John Wiley & Sons, Inc.
  • 6. Copyright © 1996, 2002 by John A. Tracy. All rights reserved.Published by John Wiley & Sons, Inc., New York.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval systemor transmitted in any form or by any means, electronic, mechanical, photo-copying, recording, scanning or otherwise, except as permitted under Sec-tions 107 or 108 of the 1976 United States Copyright Act, without either theprior written permission of the Publisher, or authorization through paymentof the appropriate per-copy fee to the Copyright Clearance Center, 222 Rose-wood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744.Requests to the Publisher for permission should be addressed to the Permis-sions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York,NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail:PERMREQ@WILEY.COM.This publication is designed to provide accurate and authoritative informa-tion in regard to the subject matter covered. It is sold with the understand-ing that the publisher is not engaged in rendering professional services. Ifprofessional advice or other expert assistance is required, the services of acompetent professional person should be sought.Wiley also publishes its books in a variety of electronic formats. Some con-tent that appears in print may not be available in electronic books.ISBN: 0-471-20285-1Printed in the United States of America.10 9 8 7 6 5 4 3 2 1
  • 7. forRichard and Robert, my dog track buddies,who have helped me more than they know.
  • 8. CONTENTSPREFACE xiii PART 1 FINANCIAL REPORTING OUTSIDE AND INSIDE A BUSINESSCHAPTER 1—GETTING DOWN TO BUSINESS 3 Accounting Inside and Out 4 Internal Functions of Accounting 6 External Functions of Accounting 6 A Word about Accounting Methods 8 End Point 9CHAPTER 2—INTRODUCING FINANCIALSTATEMENTS 11 Three Financial Imperatives, Three Financial Statements 11 Accrual-Basis Accounting 13 The Income Statement 16 The Balance Sheet 18 The Statement of Cash Flows 21 End Point 24 vii
  • 9. CONTENTS CHAPTER 3—REPORTING PROFIT TO MANAGERS 27 Using the External Income Statement for Decision-Making Analysis 27 Management Profit Report 31 Contribution Margin Analysis 35 End Point 36 CHAPTER 4—INTERPRETING FINANCIAL STATEMENTS 39 A Few Observations and Cautions 39 Premises and Principles of Financial Statements 41 Limits of Discussion 46 Profit Ratios 47 Book Value Per Share 49 Earnings Per Share 51 Market Value Ratios 53 Debt-Paying-Ability Ratios 55 Asset Turnover Ratios 58 End Point 59 PART 2 ASSETS AND SOURCES OF CAPITAL CHAPTER 5—BUILDING A BALANCE SHEET 63 Sizing Up Total Assets 63 Assets and Sources of Capital for Assets 66 Connecting Sales Revenue and Expenses with Operating Assets and Liabilities 69 Balance Sheet Tethered with Income Statement 75 End Point 76 CHAPTER 6—BUSINESS CAPITAL SOURCES 79 Business Example for This Chapter 80 Capital Structure of Business 81 Return on Investment 86 Pivotal Role of Income Tax 89 Return on Equity (ROE) 91viii
  • 10. CONTENTS Financial Leverage 92 End Point 95CHAPTER 7—CAPITAL NEEDS OF GROWTH 97 Profit Growth Plan 98 Planning Assets and Capital Growth 99 End Point 105 PART 3 PROFIT AND CASH FLOW ANALYSISCHAPTER 8—BREAKING EVENAND MAKING PROFIT 109 Adding Information in the Management Profit Report 109 Fixed Operating Expenses 112 Depreciation: A Special Kind of Fixed Cost 113 Interest Expense 116 Pathways to Profit 116 End Point 122CHAPTER 9—SALES VOLUME CHANGES 125 Three Ways of Making a $1 Million Profit 126 Selling More Units 129 Sales Volume Slippage 133 Fixed Costs and Sales Volume Changes 134 End Point 136CHAPTER 10—SALES PRICEAND COST CHANGES 139 Sales Price Changes 139 When Sales Prices Head South 144 Changes in Product Cost and Operating Expenses 146 End Point 148CHAPTER 11—PRICE/VOLUME TRADE-OFFS 149 Shaving Sales Prices to Boost Sales Volume 150 Volume Needed to Offset Sales Price Cut 154 Thinking in Reverse: Giving Up Sales Volume for Higher Sales Prices 157 End Point 159 ix
  • 11. CONTENTS CHAPTER 12—COST/VOLUME TRADE-OFFS AND SURVIVAL ANALYSIS 161 Product Cost Increases: Which Kind? 161 Variable Cost Increases and Sales Volume 163 Better Product and Service Permitting Higher Sales Price 165 Lower Costs: The Good and Bad 166 Subtle and Not-So-Subtle Changes in Fixed Costs 169 Survival Analysis 170 End Point 177 CHAPTER 13—PROFIT GUSHES: CASH FLOW TRICKLES? 179 Lessons from Chapter 2 179 Cash Flow from Boosting Sales Volumes 180 Cash Flows across Different Product Lines 185 Y Cash Flow from Bumping Up Sales Prices 185 FL End Point 188 PART 4 AM CAPITAL INVESTMENT ANALYSIS CHAPTER 14—DETERMINING INVESTMENT TE RETURNS NEEDED 191 A Business as an Ongoing Investment Project 191 Cost of Capital 192 Short-Term and Long-Term Asset Investments 195 The Whole Business versus Singular Capital Investments 196 Capital Investment Example 197 Flexibility of a Spreadsheet Model 206 Leasing versus Buying Long-Term Assets 206 A Word on Capital Budgeting 210 End Point 210 Chapter Appendix 211 CHAPTER 15—DISCOUNTING INVESTMENT RETURNS EXPECTED 213 Time Value of Money and Cost of Capital 214 Back to the Future: Discounting Investment Returns 215x
  • 12. CONTENTS Spreadsheets versus Equations 217 Discounted Cash Flow (DCF) 218 Net Present Value and Internal Rate of Return (IRR) 222 After-Tax Cost-of-Capital Rate 224 Regarding Cost-of-Capital Factors 226 End Point 227 PART 5 END TOPICSCHAPTER 16—SERVICE BUSINESSES 231 Financial Statement Differences of Service Businesses 232 Management Profit Report for a Service Business 234 Sales Price and Volume Changes 237 What about Fixed Costs? 239 Trade-off Decisions 239 End Point 241CHAPTER 17—MANAGEMENT CONTROL 243 Follow-through on Decisions 244 Management Control Information 244 Internal Accounting Controls 247 Independent Audits and Internal Auditing 249 Fraud 250 Management Control Reporting Guidelines 252 Sales Mix Analysis and Allocation of Fixed Costs 262 Budgeting Overview 270 End Point 273CHAPTER 18—MANUFACTURINGACCOUNTING 275 Product Makers versus Product Resellers 275 Manufacturing Business Example 276 Misclassification of Manufacturing Costs 280 Idle Production Capacity 283 Manufacturing Inefficiencies 285 xi
  • 13. CONTENTS Excessive Production 287 End Point 289 APPENDIX A GLOSSARY FOR MANAGERS 291 APPENDIX B TOPICAL GUIDE TO FIGURES 313 INDEX 315xii
  • 14. P R E FA C ETThis book is for business managers, as well as for bankers,consultants, lawyers, and other professionals who need asolid and practical understanding of how business makesprofit, cash flow from profit, the assets and capital needed tosupport profit-making operations, and the cost of capital.Business managers and professionals don’t have time towade through a 600-page tome; they need a practical guidethat gets to the point directly with clear and convincingexamples. In broad terms this book explains the tools of the trade foranalyzing business financial information. Financial state-ments are one primary source of such information. There-fore financial statements are the best framework to explainand demonstrate how managers analyze financial informa-tion for making decisions and keeping control. Surprisingly,most books of this ilk do not use the financial statementsframework. My book offers many advantages in this re-spect. This book explains and clearly demonstrates the indispen-sable analysis techniques that street-smart business managersuse to:• Make profit.• Control the capital invested in assets used in making profit xiii
  • 15. P R E FA C E and in deciding on the sources of capital for asset invest- ments. • Generate cash flow from profit. The threefold orientation of this book fits hand in glove with the three basic financial statements of every business: the profit report (income statement), the financial condition report (balance sheet), and the cash flow report (statement of cash flows). These three “financials” are the center of gravity for all businesses. This book puts heavy emphasis on cash flow. Business managers should never ignore the cash flow consequences of their decisions. Higher profit may mean lower cash flow; managers must clearly understand why, as well as the cash flow timing from their profit. The book begins with a four-chapter introduction to finan- cial statements. Externally reported financial statements are prepared according to generally accepted accounting princi- ples (GAAP). GAAP provide the bedrock rules for measuring profit. Business managers obviously need to know how much profit the business is earning. But, to carry out their decision-making and control func- tions, managers need more information than is reported in the external profit report of the business. GAAP are the point of departure for preparing the more informative financial statements and other internal accounting reports needed by business managers. The “failing” of GAAP is not that these accounting rules are wrong for measuring profit, nor are they wrong for presenting the financial condition of a business—not at all. It’s just that GAAP do not deal with presenting financial information to managers. In fact, much of this management information is very confidential and would never be included in an external financial report open to public view. Let me strongly suggest that you personalize every example in the book. Take the example as your own business; imagine that you are the owner or the top-level manager of the busi- ness, and that you will reap the gains of every decision or suf- fer the consequences, as the case may be. If you would like a copy of my Excel workbook file of all the figures in the book contact me at my e-mail address: tracyj@colorado.edu.xiv
  • 16. P R E FA C E As usual, the editors at John Wiley were superb. Likewise,the eagle-eyed copy editors at North Market Street Graphicspolished my prose to a much smoother finish. I would like tomention that John Wiley & Sons has been my publisher formore than 25 years, and I’m very proud of our long relation-ship. John A. Tracy Boulder, Colorado March, 2002 xv
  • 17. 1 PA R TFinancialReportingOutsideand Insidea Business
  • 18. 1 CHAPTERGetting Downto BusinessEEvery business has three primary financial tasks that deter-mine the success or failure of the enterprise and by which itsmanagers are judged:• Making profit—avoiding loss and achieving profit goals by making sales or earning other income and by controlling expenses• Cash flow—generating cash from profit and securing cash from other sources and putting the cash inflow to good use• Financial health—deciding on the financial structure for the entity and controlling its financial condition and sol- vency To continue in existence for any period of time, a business has to make profit, generate cash flow,and stay solvent. Accomplishing these financial objectives depends on doingall the other management functions well. Business managersearn their keep by developing new products and services,expanding markets, improving productivity, anticipatingchanges, adapting to new technology, clarifying the businessmodel, thinking out clear strategies, hiring and motivatingpeople, making tough choices, solving problems, and arbitrat-ing conflicts of interests between different constituencies (e.g., 3
  • 19. FINANCIAL REPORTING customers who want lower prices versus employees who want higher wages). Managers should act ethically, comply with a myriad of laws, be responsible members of society, and not harm our natural environment—all the while making profit, generating cash flow, and avoiding insolvency. ACCOUNTING INSIDE AND OUT Ask people to describe accounting and the most common answer you’ll get is that accounting involves a lot of record keeping and bookkeeping. Which is true. The account- ing system of a business is designed to capture and record all its transactions, operations, activities, and other develop- ments that have financial consequences. An accounting sys- tem generates many documents, forms, and reports. Even a small business has hundreds of accounts, which are needed to keep track of its sales and expenses, its assets and liabilities, Y and of course its cash flows. Accounting systems today are FL computer-based. The accounts of a business are kept on the hard disks of computers, which should be backed up fre- quently, of course. AM The primary purpose of an accounting system is to accu- mulate a complete, accurate, and up-to-date base of data and information needed to perform essential functions for a busi- TE ness. Figure 1.1 presents a broad overview of the internal and external functions of business accounting. Note the Janus, or two-faced, nature of an accounting system that looks in two different directions—internal and external, or inside and out- side the business. In addition to facilitating day-to-day operating activities, the accounting department of a business has the responsibility of preparing two different kinds of internal reports—very detailed reports for management control and much more con- densed reports for decision making. Likewise, the accounting department prepares two different kinds of external reports— financial reports for owners and lenders and tax returns for tax authorities. Accountants have a relatively free hand in designing control and decision-making reports for managers. In sharp contrast, external reporting is compliance-driven. External financial reports must comply with authoritative standards and established accounting rules. And, as I’m sure you know, tax returns must comply with tax laws.4
  • 20. GETTING DOWN TO BUSINESS Accounting SystemFacilitating operations External financial reportsMain examples include: Main features:• Payroll • Three primary financial state-• Purchasing ments, as well as footnotes• Billing and cash collections and other disclosures• Cash disbursements • Prepared according to gener-• Property records ally accepted accounting prin- ciples (GAAP)Management control • May be audited by CPAreports • Financial reporting by publicly owned corporations also gov-Main features: erned by federal securities• Comparison of actual per- laws formance and results against plans, goals, and timetables• Very detail oriented• Problems and out-of-control Tax returns areas highlighted Main types are: • Federal and state in- come taxesManagement decision- • Property taxesmaking reports • Sales taxesMain features: • Payroll taxes• Based on profit and cash flow models• Designed for decision- making analysis by man- agers• Global focus on primary factors that drive profit, cash flow, and financial condition FIGURE 1.1 Primary functions of accounting. 5
  • 21. FINANCIAL REPORTING INTERNAL FUNCTIONS OF ACCOUNTING In addition to the day-to-day operational demands (preparing payroll checks, paying bills on time, sending out invoices to customers, etc.), Figure 1.1 reveals two other internal functions of accounting: the preparation of manage- ment control reports and reports for management decision making. Management control demands attention to a very large number of details; quite literally, thousands of things can go wrong. Management decision making, in contrast, focuses attention on relatively few key factors. Decision mak- ing looks at the forest, not the trees. For decision-making purposes, managers need accounting reports that are con- densed and global in nature—that present the big picture. These reports should resonate with the business model and should be structured according to the profit and cash flow models of the business. In passing, I should mention that accounting information seldom comprises the whole set of information needed for decision making and control. Managers use many, many other sources of information—competitors’ sales prices, delivery problems with suppliers, employee morale, and so on. Nonaccounting data comes from a wide diversity of sources, including shopping the competition, sales force reports, market research studies, personnel department records, and so on. For example, customer files are very important, and they usually include both accounting data (past sales history) and nonaccounting data (sales reps assigned to each customer). EXTERNAL FUNCTIONS OF ACCOUNTING Accountants have two primary external reporting responsibilities: the preparation of tax returns and external financial reports (see Figure 1.1 again). Exceedingly complex and constantly changing laws, rules, and forms govern state and federal income taxes, payroll taxes, property taxes, and sales taxes. Accountants have their hands full just keeping up with tax regulations and forms. Accountants also have to stay abreast of changing accounting standards to prepare external financial reports.6
  • 22. GETTING DOWN TO BUSINESSExternal Financial ReportsIn the next chapter I present an overview of external financialreports. Please bear in mind that this book does not examinein any great detail the external financial reports of business.*This book is mainly concerned with internal reports to man-agers and how managers analyze the information in thesereports for making decisions and for controlling the financialperformance of the business. Only a few brief commentsabout external financial reporting of particular importance tomanagers are mentioned here. The financial statements of a business that are the core ofthe external financial reports sent to its shareowners andlenders must conform with generally accepted accountingprinciples (GAAP). These are the authoritative guidelines,rules, and standards that govern external financial reportingto the outside investors and creditors of a business. The mainpurpose of having financial statements audited by an inde-pendent CPA firm is to test whether the statements have beenprepared according to GAAP. If there are material departuresfrom these ground rules of financial statement accounting anddisclosure, the CPA auditor says so in the audit opinion on thefinancial statements. External financial reports include footnotes that are anintegral addendum to the financial statements. Footnotes areneeded because the external financial report is directed tooutside investors and creditors of the business who are notdirectly involved in the day-to-day affairs of the business.Managers should already know most of the information dis-closed in footnotes. If managers prefer to have certain foot-notes included in their internal accounting reports, thefootnotes should be included—probably in much more detailand covering more sensitive matters than footnotes presentedin external financial reports. An external financial report includes three primary finan-cial statements: One summarizes the profit-making activitiesof the business for the period; one summarizes the cashinflows and outflows for the same period; and one summa-rizes the assets of the business at the end of the period thatare balanced by the claims against, and sources of, the assets.*Without too much modesty, I can recommend my book, How to Read aFinancial Report, 5th ed. (New York: John Wiley & Sons, 1999). 7
  • 23. FINANCIAL REPORTING The three primary financial statements do not come with built-in analysis. Rather, the financial statements provide an organized source of information. It’s up to the users to extract the vital signals and messages from the statements. As I explain later, managers need much more information than are reported in the external financial statements. For example, suppose you’re about ready to lower sales prices 10 percent because you think sales volume will increase more than enough to make this a smart move. You’d better know which profit and cash flow analysis tools to use to test the impact of this decision on your business. The external profit report does not provide the information you need. Rather, you need the type of internal profit report explained in Chapter 3 to analyze just how much sales volume would have to increase in order to increase profit. You might be surprised by how much sales volume would have to increase. If you think sales volume would have to increase by only 10 percent, you are dead wrong! A WORD ABOUT ACCOUNTING METHODS GAAP have been developed to standardize accounting meth- ods for measuring net income (bottom-line profit), for present- ing financial condition and cash flow information, and to provide financial disclosure standards for reporting to exter- nal investors and lenders to business. Over the years GAAP have come a long way, but have not yet resulted in complete uniformity and consistency from one business to the next, or even among companies in the same industry. Businesses can choose from among different but equally acceptable account- ing methods, which can cause a material difference in the profit (net income) reported for the year and in the values of certain assets, liabilities, and owners’ equity accounts reported in the financial statements of a business. Profit depends on how it’s measured—in particular, on which accounting methods have been selected and how the methods are applied in practice. I’m reminded of the old base- ball joke here: There’s an argument between the batter and the catcher about whether the pitch was a ball or a strike. Back and forth the two go, until finally the umpire settles it by saying “It ain’t nothing until I call it.” Likewise, someone has to decide how to “call” profit for the period; profit depends on how the8
  • 24. GETTING DOWN TO BUSINESS “strike zone” is determined, and this depends heavily on which particular accounting methods are selected to measure profit. External financial reports are the primary means of com- munication to fulfill the stewardship fiduciary function of management—that is, to render a periodic accounting of what has been done with the capital entrusted to management. The creditors and shareowners of a business are the sources of, as well as having claims on, the assets of the business. There- fore, they are entitled to a periodic accounting by their stew- ards (agents is the more popular term these days). Please keep in mind that managers have a fiduciary respon-DANGER! sibility to the outside world. They are responsible for the fairness and truthfulness of the financial statements. There’s no doubt that top management has the primary responsibility for the business’s financial statements—this cannot be shifted or “outsourced” to the CPA auditor of its financial statements. Nor can legal counsel to the business be blamed if top manage- ment issues misleading financial statements, unless they were a party to a conspiracy to commit fraud. Because external financial reports are public in nature, dis- closure is limited, especially in the profit performance report of a business. Disclosure standards permit the business to withhold information that creditors and external investors probably would like to know. The theory of this, I believe, is that such disclosure would reveal too much information and cause the business to lose some of its competitive advantages. The internal accounting profit report presented in the next chapter contains confidential information that the business wouldn’t want to reveal in its external financial report to the outside world. Publicly owned corporations are required to include a man- agement discussion and analysis (MD&A) section in their annual financial reports to stockholders, which deals with the broad factors and main reasons for the company’s profit per- formance. Generally speaking, these sections are not too spe- cific and deal with broad issues and developments over the year.s END POINT The book analyzes how to make profit. So it seems a good idea in conclusion to say a few words in defense of the profit 9
  • 25. FINANCIAL REPORTING motive. Profit stimulates innovation; it’s the reward for taking risks; it’s the return on capital invested in business; it’s com- pensation for hard work and long hours; it motivates effi- ciency; it weeds out products and services no longer in demand; it keeps pressure on companies to maintain their quality of customer service and products. In short, the profit system delivers the highest standard of living in the world. Despite all this, it’s no secret that many in government, the church, and society at large have a deep- seated distrust of our profit-motivated, free enterprise, and open market system—and not entirely without reason. It would be naive to ignore the abuses and failings of the profit system and not to take notice of the ruthless profit-at- any-cost behavior of some unscrupulous business managers. Unfortunately, you don’t have to look very far to find examples of dishonest advertising, unsafe products, employees being cheated out of their pensions, dangerous working conditions, or deliberate violation of laws and regulations. Too many companies travel the low moral and ethical road. A form of Gresham’s law* seems to be at work. Dirty practices tend to drive out clean practices, the result being a sinking to the lowest level of tolerable behavior. Which is very sad. No wonder profit is a dirty word to so many. No wonder business gets bad press. Ethical standards should be above and ahead of what the law requires. Many businesses have adopted a formal code of ethics for all employees in the organization. It goes without saying that managers should set the example for full-faith compliance with the code of ethics. If managers cut corners, what do they expect employees to do? If managers pay only lip service to the code of ethics, employees will not take the code seriously. *You may recall that Sir Thomas Gresham was a sixteenth-century econo- mist who is generally credited with the important observation that, given two types of money circulating in the economy, the one perceived as more dear or of higher quality will be kept back and spent last; the cheaper or lower-quality money will be offered first in economic exchange. Thus, the cheaper money will drive out the higher-quality money. Even though we have only one currency in the American economy, you may have noticed that most of us tend to pass the currency that is in the worst shape first and hold back the bills that are in better condition.10
  • 26. 2 CHAPTERIntroducing FinancialStatementsTThis chapter introduces the financial statements that areincluded in periodic financial reports from a business to itsshareowners and lenders. They are called external financialstatements to emphasize that the information is released out-side the business. Let me stress the word introducing in thechapter title. One brief chapter cannot possibly cover thewaterfront and deal in a comprehensive manner with allaspects of external financial statements. This chapter’s objec-tive is more modest and more focused.My main purpose is to explain the basic content and structureof each financial statement in order to provide stepping-stones to later chapters, which develop models of profit, cashflow, and financial condition for management decision-makinganalysis. External financial statements are not designed formanagement use; they are designed for outside investors andlenders who do not manage the business. External financialstatements report results, but not how and why the resultshappened.THREE FINANCIAL IMPERATIVES,THREE FINANCIAL STATEMENTSWithout a doubt, managers should understand the externalfinancial statements of their business that are reported to 11
  • 27. FINANCIAL REPORTING shareowners and lenders, whether the managers own shares in the business or not. Financial statements are the basic touchstone of every business. A separate, distinct financial statement is prepared for each of the three financial impera- tives of every business: • Make profit. The income statement (also called the profit and loss statement) summarizes the revenue and expenses of the business and the profit or loss result for a period of time such as one year. • Generate cash flows. The statement of cash flows summa- rizes the various sources and uses of cash of the business for the same period as the income statement. • Control financial condition. The balance sheet (also called the statement of financial condition) summarizes the vari- ous assets and liabilities of the business at the end of the income statement period, as well as how much of the excess of assets over liabilities was invested by the share- owners in the business and how much is attributable to the cumulative profit over the life of the business that was not distributed to its shareowners. A business is profit-motivated, so its income statement (the financial statement that reports the profit or loss of the busi- ness for the period) occupies center stage. The market value of the ownership shares in the business depends heavily on the profit performance of the business. A business has to earn enough operating profit to pay the interest on its debt, so its lenders also keep sharp eye on profit performance. A Business Example I use a realistic business example to illustrate and explain the three external financial statements. This business manufac- tures and sells products to other businesses. It sells products from stock; in other words, the business carries an inventory of products from which it makes immediate delivery to cus- tomers. The business sells and buys on credit. It has invested in many long-life operating resources—buildings, machines, equipment, tools, vehicles, and computers. The business was started many years ago when several persons invested the ini- tial ownership capital in the venture. The business borrows money from banks on the basis of12
  • 28. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T Sshort-term notes (having maturity dates less than one year)and long-term notes (having maturity dates three years orlonger). The business has made a profit most years, but suf-fered losses in several years. To grow the business the share-owners invested additional capital from time to time. But themain reason for the increase in owners’ equity is that thebusiness has retained most of its annual profits in order tobuild up the capital base of the company instead of distribut-ing 100 percent of its annual profits to shareowners. For the year just ended, the business recorded $26 millionsales revenue; this amount is net of discounts given customersfrom list or billed prices. The company’s bottom-line profitafter deducting all expenses for the year from sales revenue is$2.2 million. Bottom-line profit is called variously net income,net earnings, or just earnings. (The example assumes that thebusiness did not have any nonrecurring, unusual, or extraor-dinary gains or losses during the year.) Profit equals 8.5 per-cent of sales revenue, which is typical for this industry ($2.2million profit ÷ $26 million sales revenue = 8.5%). The business uses accrual-basis accounting to meas- ure profit and to prepare its balance sheet (state-ment of financial condition). All businesses of any size that sellproducts and have inventories and that own long-lived operat-ing resources use accrual-basis accounting. Accrual-basisaccounting is required by financial reporting standards and bythe federal income tax law (with some exceptions for smallerbusinesses). Business managers should have a good grip onaccrual-basis accounting, and they should understand howaccrual-basis accounting differs from cash flows.ACCRUAL-BASIS ACCOUNTINGBefore introducing the financial statements for the businessexample, I present Figure 2.1, in which cash flows are sepa-rated from the accrual-basis components for sales andexpenses. (I culled this information from the accounts of thebusiness.) Figure 2.1 is not a financial statement. Rather, Ipresent this information to lay the groundwork for the busi-ness’s financial statements. This figure presents the basic build-ing blocks for sales revenue and expenses and for cash flows 13
  • 29. FINANCIAL REPORTING Note: Amounts are in millions of dollars. Revenue and expense cash flows Note: Cash flows include amounts related to last year’s and next year’s revenue and expenses. Accrual-basis sales revenue and expenses Note: Revenue and expenses are of this and only this year; only one year is involved. $3.2 $22.5 $3.5 Cash collections during Cash collections during Sales made during the the year from sales year from sales made year but no cash col- made last year or for sales to be made next Y $25.7 during the year. $26.0 lected during the year; cash will be collected FL year. next year or was already collected last year. AM less less TE $7.5 $14.9 $8.9 Cash payments during Cash payments during Expenses recorded dur- the year for expenses of $22.4 the year for expenses of $23.8 ing the year but not last year or next year. the year. paid during the year; cash was paid either in previous year or will be paid next year. $3.3 $2.2 Net cash flow during year Net profit for year according from operating, or profit- to accrual-basis profit making activities. accounting methods. FIGURE 2.1 Cash flow and accrual components of sales revenue and expenses for the year just ended for the business example.14
  • 30. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T Sduring the year. This information also is very helpful to under-stand the balance sheet, which is explained later in the chapter.Sales Revenue and Cash Flow from Sales RevenueThe revenue from most of the sales during the year was col-lected during the year—neither before the year started norafter the year ended. In Figure 2.1, observe that the companycollected $22.5 million cash during the year from sales madeduring the year.* To complete the accrual-basis sales revenuepicture for the year you have to consider sales made duringthe year for which cash was not collected during the year. Tocomplete the cash flow picture you have to consider othersales-driven cash flows during the year, which are either fromsales made last year or from sales that will be made next year.In summary (see Figure 2.1 for data):• Accrual-basis sales revenue for year: $22.5 million cash collections during the year from sales made during the year + $3.5 million sales made during the year but cash not col- lected during year = $26 million sales revenue for year• Sales revenue–driven cash flows during year: $22.5 mil- lion cash collections during the year from sales made dur- ing the year + $3.2 million cash collections during year from last year’s sales or for next year’s sales = $25.7 million cash flow from sales revenueExpenses and Cash Flow for ExpensesMany expenses recorded in the year were paid in cash duringthe year—neither before the year started nor after the yearended. In Figure 2.1, note that the company recorded $14.9million total expenses during the year for which it paid out$14.9 million cash during the year. Many expenses are paidweeks after the expense is originally recorded; the businessfirst records a liability on its books for the expense, and theliability account is decreased when it is paid. To complete the*The business makes many sales on credit, so cash collections from salesoccur a few weeks after the sales are recorded. In contrast, some customerspay in advance of taking delivery of products, so cash collections occurbefore the sales are recorded at the time products are delivered to the cus-tomers. 15
  • 31. FINANCIAL REPORTING cash flow picture you have to consider other cash flows during the year for expenses recorded last year or for expenses that won’t be recorded until next year. To complete the accrual- basis expenses picture for the year you have to consider expenses recorded during the year for which cash was not paid during the year. In summary (see Figure 2.1 for data): • Accrual-basis expenses for year: $14.9 million expenses recorded and paid in cash during year + $8.9 million expenses recorded but cash was not paid during year = $23.8 million expenses • Expense-driven cash flows during year: $14.9 million expenses recorded and paid in cash during year + $7.5 mil- lion paid during year for last year’s expenses or for next year’s expenses = $22.4 million cash flow for expenses Net Profit and Net Cash Flow for Year Net profit for the year is $2.2 million, equal to $26 million sales revenue less $23.8 million expenses. In contrast, the net cash flow of revenue and expenses is $3.3 million for the year. Both figures are correct. The $2.2 million figure is the correct measure of profit for the year according to proper accounting methods for recording sales revenue and expenses to the year. The $3.3 million net cash flow figure is correct, but keep in mind that cash flows related to revenue and expenses of the previous year and the following year are intermingled with the cash flows of revenue and expenses of the year just ended. THE INCOME STATEMENT Figure 2.2 presents the basic format of the business’s income statement for the year just ended. The income statement starts with sales revenue for the year and ends with the net income for the year. Between the top line and the bottom line a business reports several expenses and subtotals for intermediate measures of profit. A company that sell products discloses the amount of its cost-of-goods-sold expense imme- diately below sales revenue, which is deducted to get the first profit line, called gross margin. The word gross implies that16
  • 32. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S Note: Amounts are in millions of dollars. Sales revenue $26.0 Cost-of-goods-sold expense XX.X Gross margin XX.X Operating expenses XX.X Earnings before interest and income tax X.X Interest expense .X Earnings before income tax X.X Income tax expense X.X Net income $ 2.2 FIGURE 2.2 Format of external income statement for year.other expenses have to be deducted from sales revenue toarrive at the final, or bottom-line profit. One or more classes of operating expenses are disclosed inexternal financial statements. How many and which specifictypes of operating expenses? The disclosure of operatingexpenses varies from business to business; financial reportingrules are lax in this regard. Few businesses disclose theamounts of advertising expenses, for example, or the amountsof top-management compensation. Many businesses lump avariety of different operating expenses into a conglomerateaccount called sales, administrative, and general expenses. Inmost external income statements, total operating expenses arededucted from gross margin to arrive at the profit figurelabeled earnings before interest and income tax expenses (seeFigure 2.2). I’m sure you’ve noticed that instead of dollar amounts forexpenses and the intermediate profit lines between the topline and the bottom line in Figure 2.2 I show only placehold-ers (e.g., XX.X). Showing the dollar amounts for these itemswould serve no particular purpose here. I wish to emphasizethe basic format of the externally reported income statement,not the data in this financial statement. In Chapter 3 I developan internal profit report for managers that is a much differentformat than the external income statement, which is moreuseful for decision-making analysis. 17
  • 33. FINANCIAL REPORTING THE BALANCE SHEET The usual explanation of the balance sheet is that it is the financial statement that summarizes a business’s assets and liabilities. Well, yes and no. If you have in mind a complete reckoning of all the assets of the business at their current market or replacement values you are off the mark. The bal- ance sheet does not list all assets at current values. On the other hand, the balance sheet comes close to listing all the lia- bilities of a business. You may find these opening comments about the balance sheet rather unusual, and I don’t blame you if you think so. The accounts, or basic elements presented in a balance sheet are the result of accrual-basis accounting methods for record- ing the revenue and expenses of the business. A balance sheet in large part consists of the remains of the profit accounting process. A balance sheet is not based on a complete survey of all the tangible and intangible assets of the business at their current values. For example, a business may have developed a well known and trusted brand name and have a well trained and dedicated workforce. But these two “assets” are not reported in its balance sheet. Having these two assets should be reflected in above-average profit performance, which is reported in the income statement of the business. The chief executive can brag about these two assets in the company’s financial reports to shareowners and lenders, but don’t look for them in the company’s balance sheet. The balance sheet at the start and end of the year for the business is presented in Figure 2.3. Cash usually is shown first in a balance sheet, as you see in Figure 2.3. Cash includes coin and currency on hand, balances in demand deposit checking accounts with banks, and often cash equiva- lents such as short-term, marketable securities that can be liq- uidated at a moment’s notice. The dollar amounts reported in the balance sheet for assets other than cash and for liabilities and owners’ equity accounts are called book values, because these are the amounts recorded in the books, or accounts, kept by the business. Generally, the book values of the liabilities of a business are the amounts of cash owed to creditors and lenders that will be paid later. The book value of the asset accounts receivable is the amount of cash that should be received from customers,18
  • 34. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T SNote: Amounts are in millions of dollars.Assets Beginning End of Year of YearCash $ 1.6 $ 2.0Accounts receivable $ 2.0 $ 2.5Inventories $ 3.9 $ 4.7Prepaid expenses $ 0.5 $ 0.6Subtotal of current assets $ 8.0 $ 9.8Property, plant, and equipment $15.5 $19.1Accumulated depreciation ($ 6.5) $ 9.0 ($ 8.2) $10.9Total assets $17.0 $20.7Liabilities and Owners’ EquityAdvance payments from customers $1.0 $1.2Accounts payable $1.6 $2.0Accrued expenses payable $0.6 $0.8Short-term notes payable $1.5 $2.0Subtotal of current liabilities $ 4.7 $ 6.0Long-term notes payable $ 3.5 $ 4.0Owners’ equity—invested capital $4.0 $4.2Owners’ equity—retained earnings $4.8 $ 8.8 $6.5 $10.7Total liabilities and owners’ equity $17.0 $20.7Note: The amounts reported at the beginning of the year are the carryover balances at theend of the preceding year; the amounts continue seamlessly from the end of the precedingyear to the start of the following year.FIGURE 2.3 Format of external balance sheet.usually within a month or so. The book value of inventories(products held for sale) and property, plant, and equipmentare the costs of the assets. The cost of inventories is relativelyrecent under one method of accounting or, alternatively, rela-tively old under another. (Accountants can’t agree on just onemethod for this particular asset.) The total cost of property, plant, and equipment is relativelyold unless most of these long-lived operating resources wererecently acquired by the business. Their cost is spread over 19
  • 35. FINANCIAL REPORTING the estimated years of their use; the amount of cost that is recorded as depreciation expense is recorded in the accumu- lated depreciation offset account, which is deducted from the original cost of the assets (see Figure 2.3) When the shareowners invest capital in the business, the appropriate owners’ equity account is increased. At the end of the year the amount of profit for the year less the amount of profit distributed to the shareowners is recorded as an increase in the second owners’ equity account, which is called retained earnings (see Figure 2.3). The balance sheet assets and liabilities that are directly connected with the sales revenue and expenses of the busi- ness are summarized as follows: • Accounts receivable. Receivables from sales made on credit to customers. • Inventories. Products manufactured or purchased that have not yet been sold. • Prepaid expenses. Costs paid ahead for next year’s expenses. • Property, plant, and equipment less accumulated deprecia- tion. The original cost of long-term operating resources less the cumulative amount of the cost that has been recorded as depreciation expense so far. • Advance payments from customers. Just what the account title implies—cash received in advance from customers for future delivery of products, so sales revenue has not yet been recorded. • Accounts payable. Amounts owed to creditors for pur- chases on credit and for expenses that had not yet been paid to vendors and suppliers at balance sheet date. • Accrued expenses payable. Cumulative amounts owed for certain expenses of period that had not been paid at bal- ance sheet date. These are called operating assets and liabilities because they are generated in the operations of making sales and incurring expenses. Operating liabilities are non-interest-bearing, which sets them apart from the interest-bearing notes owed by the business. Notes payable arise from borrowing money, not from the revenue and expense operations of the business. The operating assets and liabilities of a business constitute a good20
  • 36. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T Spart of its balance sheet, as illustrated in Figure 2.3. This istypical for most businesses. The beginning and ending balances in the balance sheetshown in Figure 2.3 are the sources of the data in Figure 2.1for the cash flow and accrual-basis amounts of revenue andexpenses. The derivation of the amounts are summarized asfollows (amounts in millions of dollars):$2.00 beginning balance of accounts receivable$1.20 ending balance of advance payments from customers$3.20 cash flow from last year’s sales or for next year’s sales$2.50 ending balance of accounts receivable$1.00 beginning balance of advance payments from customers$3.50 sales made during the year but cash not collected during the year$1.60 beginning balance of accounts payable$0.60 beginning balance of accrued expenses payable$4.70 ending balance of inventories$0.60 ending balance of prepaid expenses$7.50 cash payments during year of last year’s or for next year’s expenses$1.70 depreciation expense for year (increase in accumulated depreciation)$2.00 ending balance of accounts payable$0.80 ending balance of accrued expenses payable$3.90 beginning balance of inventories$0.50 beginning balance of prepaid expenses$8.90 Expenses recorded during year but not paid during yearTHE STATEMENT OF CASH FLOWSThe third primary financial statement in the external financialreports of a business to its shareowners and lenders is thestatement of cash flows. This financial statement summarizesthe cash inflows and outflows of a business during the sameperiod as the income statement. Figure 2.4 presents thisfinancial statement for the business example. The second andthird sections of the statement of cash flows are relativelystraightforward. In the investing activities section, note thatthe business invested $3.6 million in new long-term operatingassets during the year to replace old ones that reached theend of their useful lives and to expand the production and 21
  • 37. FINANCIAL REPORTING Note: Amounts are in millions of dollars. Cash flow from operating activities Cash collections from revenue $25.7 Cash payments for expenses ($22.4) $3.3 Cash flow from investing activities Investments in new long-term operating assets ($3.6) Cash flow from financing activities Increase in short-term notes payable $ 0.5 Increase in long-term notes payable $ 0.5 Issuance of additional capital stock shares $ 0.2 Cash distributions from profit to shareowners ($ 0.5) $0.7 Net increase of cash during year $0.4 Beginning cash balance $1.6 Ending cash balance $2.0 Note: Cash flow from operating activities is presented according to the direct method, and cash outflows for expenses are condensed into one amount. FIGURE 2.4 Format of external statement of cash flows for year. warehouse capacity of the business. (Proceeds from disposals of long-term operating assets would have been reported as a cash inflow in this section.) The financing activities section in the statement of cash flows summarizes cash flows of borrowing and payments on short-term and long-term debt and investment of additional capital by shareowners during the year as well as return of capital (if any) to them. Usually, the dealings with debt sources of capital are reported net (i.e., only the net increase or increase is disclosed). Reporting practices are not completely uniform in this regard however. It is acceptable to report bor- rowings separate from payments on debt instead of just the net increase or decrease. Generally, the issuance of new own- ership shares should be reported separately from the return of capital to shareowners.22
  • 38. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S The first section of the statement of cash flows, called cashflow from operating activities (which is not the best designa-tion in the world, in my opinion), reports the cash increase ordecrease during the year from sales revenue and expenseactivities. This key figure also is called operating cash flow orcash flow from profit. To be frank, this is not an easy numberto understand. In Figure 2.4, I present cash flow from operat-ing activities about as briefly and simply as you can. Cashinflow from sales revenue was $25.7 million during the year,and cash outflow for expenses was $22.4 million during theyear, which yields the $3.3 million cash flow from profit oper-ating activities. This manner of presentation is referred to asthe direct method.Instead of the direct method, a business has the option ofusing an alternative method for presenting cash flow fromoperating activities, which is called the indirect method. Thelarge majority of businesses elect the indirect method as amatter of fact—even though the financial reporting rule-making body of the accounting profession has expressed apreference for the direct method. The indirect method isexplained next.Indirect Method of Reporting Cash Flowfrom Operating ActivitiesBased on changes in the operating assets and liabilities fromthe beginning of the year to the end of the year, Figure 2.5shows how the business’s cash flow from operating activitieswould be presented in its statement of cash flows for the year. The indirect method starts with net income for the year,then “adjusts” net income for the cash flow effects due tochanges in the assets and liabilities that are directly connectedwith recording sales revenue and expenses (called operatingassets and liabilities). Of course, the $3.3 million cash flowfrom operating activities for the year is the same whether thedirect or the indirect method of presentation is used in thestatement of cash flows. To follow the indirect method of pre-sentation, keep in mind the following basic points:• An increase in operating assets causes a negative effect on cash flow from profit, and a decrease causes a positive effect. 23
  • 39. FINANCIAL REPORTING Net income $2.2 Accounts receivable increase (0.5) Inventories increase (0.8) Prepaid expenses increase (0.1) Depreciation expense 1.7 Advance payments from customers increase 0.2 Accounts payable increase 0.4 Accrued expenses payable increase 0.2 Cash flow from operating activities $3.3 FIGURE 2.5 Indirect method of reporting cash flow from operating activities. • An increase in operating liabilities causes a positive effect on cash flow from profit, and a decrease causes a negative Y effect. FL In most situations, the largest decrease in an operating asset is the depreciation expense recorded for the year. Depre- ciation expense is recorded in order to allocate a portion of AM the total cost of a business’s long-term operating assets to the year. Recording depreciation expense is not a cash outlay; rather, it is the write-down of the long-term operating assets TE of the business that were bought and paid for in previous years. Note in Figure 2.5 that depreciation expense is by far the largest single factor in cash flow from operating activities.s END POINT A business makes regular financial reports to its shareowners and lenders. Because they supply capital to the business, they are entitled to receive regular reports about what the business has done with their money. The hard core of these reports consists of three primary financial statements. They are called external financial statements because the information is released outside the business. The income statement reports the revenue, expenses, and profit or loss of the business for the period. Recording revenue and expenses is based on accrual-basis accounting methods. The chapter begins by explaining the key differences between cash flows and accrual-basis profit accounting. Then the format24
  • 40. I N T R O D U C I N G F I N A N C I A L S TAT E M E N T Sand content of each of the three primary financial statementsis illustrated and explained for a typical business. The external financial statements are oriented to the out-side shareowners and lenders of the business who are notinvolved in managing the business. The development of thestandards and conventions for presenting external financialstatements has been guided by this basic orientation. Fortheir decision-making and control functions, business man-agers need more useful internal profit reports, which Idevelop in the next chapter. 25
  • 41. 3 CHAPTER Reporting Profit to ManagersM Managers have to keep on top of the unending stream of changes in today’s business environment. Few factors remain constant very long. Managers need to quickly assess the profit and other financial impacts of these changes. Deciding on the best response to changes is never easy, but one thing is clear: Managers need all relevant information for their profit- making decision analysis. USING THE EXTERNAL INCOME STATEMENT FOR DECISION-MAKING ANALYSIS The external income statement (see Figure 2.2) is useful up to a point for decision-making analysis, but it does not present all the information about operating expenses that is needed by managers. To demonstrate this important point, consider the following situation. Suppose you have done extensive market research and you’re convinced that reducing sales prices across the board next year by just 5 percent would result in a 25 percent increase in sales volume across the board. In order to concentrate on this basic decision, assume zero cost infla- tion next year (don’t you wish!). Would this be a good move? Of course, your prediction of a 25 percent sales volumeDANGER! increase is critical. This big jump in sales volume may or may not materialize. Such a large response to shaving sales prices implies that sales demand is very sensitive to sales 27
  • 42. FINANCIAL REPORTING prices. In other words, you face a very elastic demand curve, as economists say. Does the external income statement pro- vide all the information needed to analyze this decision? No, not entirely. The external profit report (income statement) doesn’t include enough information about how operating expenses would react to the sales volume increase and the sales revenue increase. External Income Statement for New Example Figure 3.1 presents the external income statement for the most recent year for a new business example. This external profit performance report has been prepared according to generally accepted accounting principles (GAAP) regarding the format and disclosure standards for this key financial statement. Be warned, however, that every business is a little different when it comes to details in their income statements. Terminology differs somewhat from business to business. For instance, some companies prefer the term gross profit instead of gross margin in their external income statements (sales revenue minus cost-of-goods-sold expense). Many businesses report two or more classes of operating expenses below the gross margin line instead of just one amount for all selling and administrative expenses as shown in Figure 3.1. For instance, a business may disclose the amount of its research and devel- opment expense for the year as separate from all its other operating expenses. Nevertheless, the example shown in Sales revenue $39,661,250 Cost-of-goods-sold expense $24,960,750 Gross margin $14,700,500 Selling and administrative expenses $11,466,135 Earnings before interest and income tax $ 3,234,365 Interest expense $ 795,000 Earnings before income tax $ 2,439,365 Income tax expense $ 853,778 Net income $ 1,585,587 FIGURE 3.1 External income statement for most recent year.28
  • 43. REPORTING PROFIT TO MANAGERSFigure 3.1 is an archetype external income statement inessential respects. I should quickly mention that externalfinancial statements are supplemented with footnotes (whichare not shown for the example).Analyzing Gross MarginThe first step in making a bottom-line profit for the year is tomake enough gross margin to cover your operating expensesfor the year and to cover your interest expense and incometax expense as well. The cost-of-goods-sold expense isdeducted from sales revenue to arrive at this extremelyimportant first-line measure of profit (see Figure 3.1). As its name implies, cost-of-goods-sold expense is the costof the products sold to customers. Cost of goods sold is usuallythe largest expense for a business that sells products, typically50 to 60 percent or more of sales revenue (and as much as 80to 85 percent for some high-volume retailers). The gross margin ratio on sales varies from industry toindustry, as you probably know. The cosmetics industry hasvery high gross profit margins, and Coca-Cola’s gross profittraditionally has been over 60 percent. A full-service restau-rant, as a rough rule of thumb, should keep its food costs atone-third of its sales revenue, leaving a two-thirds gross mar-gin to cover all its other expenses and to yield a satisfactorybottom-line profit. In the past, Apple Computer made very highgross margins until it adopted a much more aggressive salesprice strategy on its personal computers to protect its marketshare. This cut deeply into its historically high profit margins.A general rule is that the lower the gross margin ratio, thehigher the inventory turnover. The interval of time fromacquisition of the product to the sale of the product equals oneinventory turnover. High turnover generally is five or moreturns a year, or maybe six or seven turns a year depending onwhom you talk with. Food supermarkets, for example, haveextremely high inventory turnover—their products do not stayon the shelves very long. Even taking into account the holdingperiod in their warehouses before the products get to theshelves in the stores, their inventory turnover is very high,and thus supermarkets can work on fairly thin gross marginpercents of 20 percent, give or take a little. 29
  • 44. FINANCIAL REPORTING In contrast, a retail furniture store may hold an item in inventory for more than six months on average before it is sold, so they need fairly high gross margin percents. In this business example, the company’s gross margin is 37.1 percent of its sales revenue ($14,700,500 gross margin ÷ $39,661,250 sales revenue = 37.1% gross margin ratio). This is in the ball- park for many businesses. Cost of goods sold is a variable expense; it moves more or less in lockstep with changes in sales volume (total number of units sold). If sales volume were to increase 10 percent, then this expense should increase 10 percent, too, assuming unit product costs remained constant over time. But unit product costs—whether the company is a retailer that pur- chases the products its sells or a producer that manufactures the products it sells—do not remain constant over time. Unit product costs may drift steadily upward over time with infla- tion. Or unit product costs can take sharp nosedives because of technological improvements or competitive pressures. Returning to the decision situation introduced previously, the manager can use the information in the external income statement to do the gross margin analysis presented in Figure 3.2, which compares sales revenue, cost-of-goods-sold expense, and gross margin for the year just ended and for the contem- plated scenario in which sales prices are 5 percent lower and sales volume is 25 percent higher. Before looking at Figure 3.2, you might make an intuitive guess regarding what would happen to gross margin in this scenario, then compare your guess with what the numbers show. I’d bet that you are some- what surprised by the outcome shown in Figure 3.2. But num- bers don’t lie. Sales revenue would increase 18.75 percent: Although sales volume would increase 25.0 percent, the sales price of every unit sold would be only 95 percent of what it sold for during the year just ended. (Note that 1.25 × 0.95 = 1.1875, or an 18.75 percent increase in sales revenue.) Cost-of-goods-sold expense would increase 25.0 percent because sales volume, or the total number of units sold, would increase 25.0 percent. Still, gross margin would increase 8.14 percent, although this is far less than the percent increase in sales volume. What about operating expenses? Would the total of these30
  • 45. REPORTING PROFIT TO MANAGERS For Year Just Ended For New Percent (Figure 3.1) Scenario Change ChangeSales revenue $39,661,250 $47,097,734 $7,436,484 18.75%Cost-of-goods-sold expense $24,960,750 $31,200,938 $6,240,188 25.00%Gross margin $14,700,500 $15,896,796 $1,196,296 8.14%FIGURE 3.2 Gross margin analysis of sales price cut proposal. expenses (excluding interest and income tax expenses) increase more than the increase in gross margin? Without more information about the business’s operating expenses there’s no way to answer this question. You need information about how the operating expenses would react to the relatively large increase in sales volume and sales revenue. The internal management profit report presents this key information. MANAGEMENT PROFIT REPORT Figure 3.3 presents the management profit report for the business example. (In this internal financial statement I show expenses with parentheses to emphasize that they are deductions from profit.) Instead of one amount for selling and administrative expenses as presented in the external income statement, note that operating expenses are classified accord- ing to how they behave relative to changes in sales volume and sales revenue (see the shaded area in Figure 3.3). Vari- able operating expenses are separated from fixed operating expenses, and the variable expenses are divided into revenue- driven versus unit-driven. This three-way classification of operating expenses is the key difference between the external and internal profit reports. Also note that a new profit line is included, labeled contribution margin, which equals gross margin minus variable operating expenses. It is called this because this profit contributes toward coverage of fixed operating expenses and toward interest expense, which to a large degree is also fixed in amount for the year. 31
  • 46. FINANCIAL REPORTING Sales revenue $39,661,250 Cost-of-goods-sold expense ($24,960,750) Gross margin $14,700,500 Variable revenue-driven operating expenses ($ 3,049,010) Variable unit-driven operating expenses ($ 2,677,875) Contribution margin $ 8,973,615 Fixed operating expenses ($ 5,739,250) Earnings before interest and income tax (EBIT) $ 3,234,365 Interest expense ($ 795,000) Earnings before income tax $ 2,439,365 Income tax expense ($ 853,778) Net income $ 1,585,587 FIGURE 3.3 Management profit report for business example. Bottom-line profit (net income) is exactly the same amount as in the external income statement (Figure 3.1). Contrary to what seems to be a popular misconception, businesses do not keep two sets of books. Profit is measured and recorded by one set of methods, which are the same for both internal and external financial reports. Managers may ask their accounting staff to calculate profit using alternative accounting methods, such as a different inventory and cost-of-goods-sold expense method or a different depreciation expense method, but only one set of numbers is recorded and booked. There is not a “real” profit figure secreted away someplace that only man- agers know, although this seems to be a misconception held by many. The additional information about operating expenses pro- vided in the management profit report (see Figure 3.3) allows the manager to complete his or her analysis and reach a deci- sion. Before walking through the analysis of the proposal to cut sales prices by 5 percent to gain a 25 percent increase in sales volume, it is important to thoroughly understand the behavior of operating expenses. Variable Operating Expenses In the management profit report (Figure 3.3), variable operat- ing expenses are divided into two types: those that vary with32
  • 47. REPORTING PROFIT TO MANAGERSsales volume and those that vary with total sales dollars. Ingeneral, variable means that an expense varies with salesactivity—either sales volume (the number of units sold) orsales revenue (the number of dollars generated by sales).Delivery expense, for example, varies with the quantity ofunits sold and shipped. On the other hand, commissions paidto salespersons normally are a percentage of sales revenue orthe number of dollars involved. Contribution margin, which equals sales revenue minuscost-of-goods-sold and variable operating expenses, has to belarge enough to cover the company’s fixed operating expenses,its interest expense, and its income tax expense and still leavea residual amount of final, bottom-line profit (net income). Inshort, there are a lot of further demands on the stepping-stone measure of profit called contribution margin. Even if abusiness earns a reasonably good total contribution margin, itstill isn’t necessarily out of the woods because it has fixedoperating expenses as well as interest and income tax.In this business example, contribution margin equals 22.6percent of sales revenue ($8,973,615 contribution margin ÷$39,661,250 sales revenue = 22.6%). For most managementprofit-making purposes, the contribution margin ratio is themost critical factor to watch closely and keep under control.Gross margin is important, to be sure, but the contributionmargin ratio is even more important. The contribution marginis an important line of demarcation between the variableprofit factors above the line and fixed expenses below the line.Fixed ExpensesVirtually every business has fixed operating expenses as wellas fixed depreciation expense. The company’s fixed operatingexpenses were $5,739,250 for the year, which includes depre-ciation expense because it is a fixed amount recorded to theyear regardless of whether the long-term operating assets ofthe business were used heavily or lightly during the period.Depreciation depends on the choice of accounting methodsadopted to measure this expense—whether it be the level,straight-line method or a quicker accelerated method. Otherfixed operating expenses are not so heavily dependent on thechoice of accounting methods compared with depreciation. 33
  • 48. FINANCIAL REPORTING Fixed means that these operating costs, for all practical purposes, remain the same for the year over a fairly broad range of sales activity—even if sales rise or fall by 20 or 30 percent. Examples of such fixed costs are employees on fixed salaries, office rent, annual property taxes, many types of insurance, and the CPA audit fee. Once-spent advertising is a fixed cost. Generally speaking, these cost commitments are decided in advance and cannot be changed over the short run. The longer the time horizon, on the other hand, the more these costs can be adjusted up or down. For instance, persons on fixed salaries can be laid off, but they may be entitled to several months or perhaps one or more years of severance pay. Leases may not be renewed, but you have to wait to the end of the existing lease. Most fixed operating expenses are cash-based, which means that cash is paid out at or near the time the expense is recorded—though it must be mentioned that some of these costs have to be pre- Y paid (such as insurance) and many are paid after being FL recorded (such as the CPA audit fee). In passing, it should be noted that other assets are occasion- AM ally written down, though not according to any predetermined schedule as for depreciation. For example, inventory may have to be written down or marked down if the products can- TE not be sold or will have to be sold below cost. Inventory also has to be written down to recognize shrinkage due to shoplift- ing and employee theft. Accounts receivables may have to be written down if they are not fully collectible. (Inventory loss and bad debts are discussed again in later chapters.) Managers definitely should know where such write-downs are being reported in the profit report. For instance, are inventory knockdowns included in cost-of-goods-sold expense? Are receivable write-offs in fixed operating expenses? Man- agers have to know what all is included in the basic accounts in their internal profit report (Figure 3.3). Such write-downs are generally fixed in amount and would not be reported as a variable expense—although if a certain percent of inventory shrinkage is normal then it should be included with the vari- able cost-of-goods-sold expense. The theory of putting it here is that to sell 100 units of product, the business may have to buy, say, 105 units because 5 units are stolen, damaged, or otherwise unsalable.34
  • 49. REPORTING PROFIT TO MANAGERS CONTRIBUTION MARGIN ANALYSIS The next step in the decision analysis, based on the informa- tion in the management profit report (Figure 3.3), is to deter- mine how much the business’s variable operating expenses would increase based on the sales revenue increase and the sales volume increase. Figure 3.4 presents this analysis, and the results are not encouraging. The variable revenue-driven operating expenses would increase by the same percent as sales revenue, and the variable unit-driven expenses would increase by the same percent as sales volume. The result is that contribution margin would decrease $44,863 (see Figure 3.4). This is before taking into account what would happen to fixed operating expenses at the higher sales volume level. Fixed operating expenses are those that are not sensitive to incremental changes in actual sales volume. However, a busi- ness can increase sales volume only so much before some of its fixed operating expenses have to be increased. For exam- ple, one fixed operating expense is the cost of warehouse space (rent, insurance, utilities, etc.). A 25 percent increase in sales volume may require the business to rent more warehouse For Year Just New Percent Ended Scenario Change ChangeSales revenue $39,661,250 $47,097,734 $7,436,484 18.75%Cost-of-goods-sold expense ($24,960,750) ($31,200,938) ($6,240,188) 25.00%Gross margin $14,700,500 $15,896,796 $1,196,296 8.14%Variable revenue-driven operating expenses ($ 3,049,010) ($ 3,620,700) ($ 571,690) 18.75%Variable unit-driven operating expenses ($ 2,677,875) ($ 3,347,344) ($ 669,469) 25.00%Contribution margin $ 8,973,615 $ 8,928,752 ($ 44,863) −0.50%Fixed operating expenses ($ 5,739,250)Earnings before interest and income tax (EBIT) $ 3,234,365Interest expense ($ 795,000)Earnings before income tax $ 2,439,365Income tax expense ($ 853,778)Net income $ 1,585,587FIGURE 3.4 Contribution margin analysis of sales price cut proposal. 35
  • 50. FINANCIAL REPORTING space. In any case, you may decide to break off the analysis at this point since contribution margin would decrease under the sales price cut proposal. You might be tempted to pursue the sales price reduction plan in order to gain market share. Well, perhaps this would be a good move in the long run, even though it would not increase profit immediately. The point about market share reminds me of a line in a recent article in the Wall Street Journal: “Stop buying market share and start boosting prof- its.” The sales price reduction proposal takes too big a bite out of profit margins, even though sales prices would be reduced only 5 percent. Even given a 25 percent sales volume spurt, you would see a decline in contribution margin even before taking into account any increases in fixed operating expenses.s END POINT The external income statement is useful for management decision-making analysis, but only up to a point. It does not provide enough information about operating expense behav- ior. The internal profit report to managers adds this important information for decision-making analysis. In management profit reports, operating expenses are separated into variable and fixed, and variable expenses are further separated into those that vary with sales volume and those that vary with sales revenue dollars. The central importance of the proper classification of operating expenses cannot be overstated. This chapter walks through the analysis of a proposal to reduce sales prices in order to stimulate a sizable increase in sales volume. Using information from the external income statement, the impact of the proposal on gross margin is ana- lyzed. To complete the analysis, managers need the informa- tion about operating expenses that is reported in the internal profit report. After analyzing the changes in variable operat- ing expenses, it is discovered that contribution margin (profit before fixed operating expenses are deducted) would actually decrease if the sales price reduction were implemented. Fur- thermore, the sizable increase in sales volume raises the possibility that fixed operating expenses might have to be increased to accommodate such a large jump in sales volume. Future chapters look beyond just the profit impact and con- sider other financial effects of changes in sales volume, sales36
  • 51. REPORTING PROFIT TO MANAGERSrevenue, and expenses—in particular, the impacts on cashflow from profit. A basic profit model and basic cash flowfrom profit model are developed in future chapters andapplied to a variety of decision situations facing businessmanagers. The discussion in this chapter is for the companyas a whole (i.e., assuming all sales prices would be reduced).Of course, in actual business situations sales price changesare more narrowly focused on particular products or productlines. The profit model developed in later chapters can beapplied to any segment or profit module of the business. 37
  • 52. 4 CHAPTERInterpreting FinancialStatementsFFinancial statements are the main and often the only sourceof information to the lenders and the outside investors regard-ing a business’s financial performance and condition. In addi-tion to reading through the financial statements, they usecertain ratios calculated from the figures in the financialstatements to evaluate the profit performance and financialposition of the business. These key ratios are very importantto managers as well, to say the least. The ratios are part of thelanguage of business. It would be embarrassing to a managerto display his or her ignorance of any of these financial speci-fications for a business.A FEW OBSERVATIONS AND CAUTIONSThis chapter focuses on the financial statements included inexternal financial reports to investors. These financial reportscirculate outside the business; once released by a business, itsfinancial statements can end up in the hands of almost any-one, even its competitors. The amounts reported in externalfinancial statements are at a summary level; the detailedinformation used by managers is not disclosed in externalfinancial statements. External financial statements disclose agood deal of information to its investors and lenders that theyneed to know, but no more. There are definite limits on theinformation divulged in external financial statements. For 39
  • 53. FINANCIAL REPORTING instance, a business does not present a list of its major cus- tomers or stockholders in its external financial statements. External financial statements are general purpose in nature and comprehensive of the entire business. The amounts reported for some assets—in particular, inventories and fixed assets—may be fairly old costs, going back several years. As mentioned in Chapter 2, assets are not marked up to current market values. The current replacement values of assets are not reported in external financial statements. Profit accounting depends on many good faith estimates. Managers have to predict the useful lives of its fixed assets for recording annual depreciation expense. They have to estimate how much of its accounts receivable may not be collectible, which is charged off to bad debts expense. Managers have to estimate how much to write down its inventories and charge to expense for products that cannot be sold or will have to be sold at prices below cost. For products already sold, they have to forecast the future costs of warranty and guarantee work, which is charged to expense in the period of recording the sales. Managers have to predict several key variables that determine the cost of its employees’ retirement plan. The amount of retirement benefit cost that is recorded to expense in the current year depends heavily on these estimates. Because so many estimates have to be made in recording expenses, the net income amount in an income statement should be taken with a grain of salt. This bottom-line profit number could have been considerably higher or lower. Much depends on the estimates made by the managers in recording its sales and expenses—as well as which particular accounting methods are selected (more on this later). I don’t like to say it, but in many cases the managers of a business manipulate its external financial statements to one degree or another. Managers influence or actually dictate which estimates are used in recording expenses ( just mentioned). Managers also decide on the timing of recording sales revenue and certain expenses. Managers massage sales revenue and expenses numbers in order to achieve preestablished targets for net income and to smooth the year-to-year fluctuations of net income. Managers should be careful, however. It’s one thing to iron out the wrinkles and fluff up the pillows in the financial40
  • 54. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S statements, but if managers go too far, they may cross the line and commit financial fraud for which they are legally liable. Financial statements of public corporations are required toDANGER! have annual audits by an independent CPA firm; many pri- vate companies also opt to have annual CPA audits. How- ever, CPA auditors don’t necessarily catch all errors and fraud. With or without audits, there’s a risk that the financial state- ments are in error or that the business has deliberately pre- pared false and misleading financial statements. During the past decade, an alarming number of public corporations have had to go back and restate their profit reports following the discovery of fraud and grossly misleading accounting. This is most disturbing. Investors and lenders depend on the reliabil- ity of the information in financial statements. They do not have an alternative source for this information—only the financial statements. PREMISES AND PRINCIPLES OF FINANCIAL STATEMENTS The shareowners of a business are entitled to receive on a regular basis financial statements and other financial infor- mation about the business. Financial statements are the main means of communication by which the management of a busi- ness renders an accounting, or a summing-up, of their stew- ardship of the business entrusted to them by the investors in the business. The quarterly and annual financial reports of a business to its owners contain other information. However, the main purpose of a financial report is to submit financial statements to shareowners. Generally accepted accounting principles (GAAP) and financial reporting standards have been extensively developed over the last half century. These guidelines rest on one key premise— the separation of management of a business from the outside investors in the business. In the formulation of GAAP it is assumed that financial statements are for those who have supplied the ownership capital to a business but who are not directly involved in managing the business. Financial state- ments are prepared for the “absentee owners” of a business, in other words. GAAP and financial reporting standards do not ignore the need for information by the lenders to a business. 41
  • 55. FINANCIAL REPORTING But the shareowners of the business are the main con- stituency for whom financial statements are prepared. Federal law governs the communication of financial infor- mation by businesses whose capital stock shares are traded on public markets. The federal securities laws are enforced mainly by the Securities and Exchange Commission (SEC), which was established in 1934. Also, the New York Stock Exchange, Nasdaq, and other securities markets enforce many rules and regulations regarding the release and commu- nication of financial information by companies whose securi- ties are traded on their markets. For instance, a business cannot selectively leak information to some stockholders or lenders and not to others, nor can a business tip off some of them before informing others later. The laws and require- ments of financial reporting are designed to ensure that all stockholders and lenders have equal access to a company’s financial information and financial statements. A business’s financial statements may not be the first news about its profit performance. Public corporations put out press releases concerning their earnings for the period just ended before the company releases its actual financial statements. Privately owned businesses do not usually send out letters about profit performance in advance of releasing their finan- cial statements—although they could do this. Financial Statements Example Chapter 3 introduced the external income statement for a business, followed by the internal management profit report for the business. Now the complete set of financial statements for the business is presented, which consists of the following: • Income statement for the year just ended (Figure 4.1) • Statement of financial condition at the close of the year just ended and at the close of the preceding year (Figure 4.2) • Statement of cash flows for the year just ended (Figure 4.3) • Statement of changes in stockholders’ equity for the year just ended (Figure 4.4) The income statement ranks first in terms of readability and intuitive understandability. Most people understand that profit equals revenue less expenses, although the technical jargon in42
  • 56. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Sales revenue $39,661,250 Cost-of-goods-sold expense $24,960,750 Gross margin $14,700,500 Selling and administrative expenses $11,466,135 Earnings before interest and income tax $ 3,234,365 Interest expense $ 795,000 Earnings before income tax $ 2,439,365 Income tax expense $ 853,778 Net income $ 1,585,587 Earnings per share* $ 3.75 *Privately owned business corporations do not have to report earnings per share; publicly owned corporations are required to disclose this key ratio in their income statements. FIGURE 4.1 Income statement for the year just ended.income statements is a barrier to many readers. The balancesheet (or statement of financial condition) ranks second.Assets and liabilities are familiar to most people—althoughthe values reported in this financial statement are not imme-diately obvious to many readers. The statement of cash flowsis presented in a very technical format that makes the state-ment very difficult to read, even for sophisticated investors.The footnotes that accompany the company’s financial state-ments are not presented here for the business. Footnotesoften run several pages. Footnotes, although difficult andtime-consuming to read through, contain very importantinformation. Stock analysts and investment managers scourthe footnotes in financial reports, digging for important infor-mation about the business. The footnotes are not needed forexplaining financial statement ratios. (For a discussion of foot-notes, see Chapter 16 in my book How to Read a FinancialReport, 5th ed., John Wiley & Sons, 1999.) Publicly owned businesses present their financial state-ments in a format that compares the most recent three years(as required by SEC rules). The three-year comparative formatmakes it easier to follow trends, of course. Many privately 43
  • 57. FINANCIAL REPORTING Assets At Close of At Close of Year Just Preceding Ended Year Cash $ 2,345,675 $ 2,098,538 Accounts receivable $ 3,813,582 $ 3,467,332 Inventories $ 5,760,173 $ 4,661,423 Prepaid expenses $ 822,899 $ 770,024 Total current assets $12,742,329 $10,997,317 Property, plant, and equipment $20,857,500 $18,804,030 Accumulated depreciation ($ 6,785,250) ($ 6,884,100) Cost less accumulated depreciation $14,072,250 $11,919,930 Total assets $26,814,579 $22,917,247 Liabilities and Owners’ Equity Accounts payable Accrued expenses payable Y $ 2,537,232 $ 1,280,214 $ 2,180,682 $ 1,136,369 FL Income tax payable $ 58,650 $ 117,300 Short-term debt $ 2,250,000 $ 1,765,000 Total current liabilities $ 6,126,096 $ 5,199,351 AM Long-term debt $ 7,500,000 $ 5,850,000 Total liabilities $13,626,096 $11,049,351 Capital stock (422,823 and 420,208 shares) $ 4,587,500 $ 4,402,500 TE Retained earnings $ 8,600,983 $ 7,465,396 Total owners’ equity $13,188,483 $11,867,896 Total liabilities and owners’ equity $26,814,579 $22,917,247 FIGURE 4.2 Statement of financial condition at close of the year just ended and at close of the preceding year. owned businesses present their financial statements for two or three years, although practice is not uniform in this respect. The company’s income statement (Figure 4.1) and statement of cash flows (Figure 4.3) are presented for the most recent year only. The statement of financial condition (Figure 4.2) is presented at the close of its two most recent two years. Finan- cial statement ratios are calculated for each year. The ratios are calculated the same way for all years for which financial44
  • 58. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T SCash Flows from Operating ActivitiesNet income $1,585,587Changes in operating assets and liabilities:Accounts receivable ($ 346,250)Inventories ($1,098,750)Prepaid expenses ($ 52,875)Depreciation expense $ 768,450Accounts payable $ 356,550Accrued expenses payable $ 143,845Income tax payable ($ 58,650)Cash flow from operating activities $1,297,907Cash Flows from Investing ActivitiesInvestment in property, plant, and equipment ($3,186,250)Proceeds from disposals of property, plant, and equipment $ 265,480Cash used in investing activities ($2,920,770)Cash Flows from Financing ActivitiesNet increase in short-term debt $ 485,000Increase in long-term debt $1,650,000Issuance of capital stock shares $ 185,000Cash dividends to stockholders ($ 450,000)Cash from financing activities $1,870,000Cash increase during year $ 247,137Cash balance at beginning of year $2,098,538Cash balance at end of year $2,345,675FIGURE 4.3 Statement of cash flows for the year just ended.statements are presented. As a general rule, only a few ratiosare presented in most financial reports. Thus investors andlenders have to calculate ratios or look in financial informa-tion sources that report the financial statement ratios for busi-nesses. The business in this example is a corporation that is ownedby a relatively small number of persons who invested the capi-tal to start the business some years ago. The business has over$39 million annual sales (see Figure 4.1). Many publicly ownedcorporations are much larger than this, and most privatelyowned businesses are smaller. Size is not the point, however. 45
  • 59. FINANCIAL REPORTING Capital Retained Stock Earnings Beginning balances (420,208 shares) $4,402,500 $7,465,396 Net income for year $1,585,587 Shares issued during year (2,615 shares) $ 185,000 Dividends paid during year ($ 450,000) Ending balances (422,823 shares) $4,587,500 $8,600,983 FIGURE 4.4 Statement of changes in stockholders’ equity for the year just ended. The techniques of financial analysis and the ratios discussed in the chapter are appropriate for any size of business. LIMITS OF DISCUSSION The chapter does not pretend to cover the broad field of secu- rities analysis (i.e., the analysis of stocks and debt securities issued by public corporations that are traded in public market- places). This broad field includes the analysis of the competi- tive advantages and disadvantages of a business, domestic and international economic developments affecting a business, business combination possibilities, political developments, court decisions, technological advances, demographics, investor psychology, and much more. The key ratios explained in this chapter are the basic building blocks used in securities analysis. The chapter does not discuss trend analysis, which involves comparing a company’s latest financial statements with its previous years’ statements to identify important year-to-year changes. For example, investors and lenders are very inter- ested in the sales growth or decline of a business and the resulting impact on profit performance, cash flows, and finan- cial condition. The chapter has a more modest objective—to explain the basic ratios used in financial statement analysis. Only a handful of ratios are discussed in the chapter, but they are extremely important and widely used. The business example does not include any extraordinary gains or losses for the year. Extraordinary means onetime,46
  • 60. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S nonrecurring events. For example, a business may sell off or abandon a major segment of its operations and record a large loss or gain. A business may record a substantial loss caused by a major restructuring or downsizing of the organization to recognize the cost of terminating employees who will receive severance packages or early-retirement bonuses. A business may lose a major lawsuit and have to pay a huge fine or dam- age award. A business may write off most of its inventories due to a sudden fall in demand for its products. The list goes on and on. These nonordinary, unusual gains and losses are reported separately from the ongoing, continuing operations of a company. Extraordinary gains and losses are very frustrating in ana-DANGER! lyzing profit performance for investors, creditors, and man- agers alike. Making matters worse is that many businesses record huge amounts of extraordinary losses in one fell swoop in order to clear the decks of these costs and losses in future years. This is called “taking a big bath.” Quite clearly, many managers prefer this practice. In public discussions, the investment community wrings their hands and lambastes this practice, as you see in many articles and editorials in the financial press. However, I think many investors would admit in private that they prefer that a business take a big bath in one year and thereby escape losses and expenses in future years. The thinking is that taking a big bath allows a business to start over by putting bad news behind it, wiping the slate clean so that future years escape these charges. PROFIT RATIOS Owners take the risk of whether their business can earn a profit and sustain its profit performance over the years. How much would you be willing to pay for a business that reports a loss year after year? The value of the owners’ investment depends first and foremost on the profit performance of the business. Making sales and controlling expenses is how a business makes profit, of course. The profit residual from sales revenue is measured by a return-on-sales ratio, which equals a particular measure of profit divided by sales revenue for the period. An income statement reports several profit lines, beginning with gross margin down to bottom-line net income. 47
  • 61. FINANCIAL REPORTING Figure 4.5 shows four profit ratios for the business example; each ratio equals the profit on that line divided by sales rev- enue. These return-on-sales profit ratios are not required to be disclosed in the income statement. Generally speaking, businesses do not report profit ratios with their external income statements, although many companies comment on one or more of their profit ratios elsewhere in their financial reports. Managers should pay very close attention to the profit ratios of their business of course. The company’s net income return on sales ratio is 4.0 per- cent ($1,585,587 net income ÷ $39,661,250 sales revenue = 4.0%). From each $100.00 of its sales revenue, the business earned $4.00 net income and had expenses of $96.00. The net income profit ratio varies quite markedly from one indus- try to another. Some businesses do well with only a 1 or 2 percent return on sales; others need more than 10 percent to justify the large amount of capital invested in their assets. A popular misconception of many people is that most busi- nesses rip off the public because they keep 20, 30, or more percent of their sales revenue as bottom-line profit. In fact, very few businesses earn more than a 10 percent bottom-line profit on sales. If you don’t believe me, scan a sample of 50 or 100 earnings reports in the Wall Street Journal or the New York Times. The 4.0 percent net income profit ratio in the Profit Income Statement Ratios Sales revenue $39,661,250 Cost-of-goods-sold expense $24,960,750 Gross margin $14,700,500 37.1% Selling and administrative expenses $11,466,135 Earnings before interest and income tax $ 3,234,365 8.2% Interest expense $ 795,000 Earnings before income tax $ 2,439,365 6.2% Income tax expense $ 853,778 Net income $ 1,585,587 4.0% FIGURE 4.5 Return-on-sales profit ratios.48
  • 62. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T Sexample is not untypical, although 4.0 percent is a little lowcompared with most businesses. Serious investors watch all the profit ratios shown in Figure4.5. The first ratio—the gross margin return-on-sales ratio—isthe starting point for the other profit ratios. Gross margin(also called gross profit) equals sales revenue minus only cost-of-goods-sold expense. The company’s gross margin equals37.1 percent of sales revenue (see Figure 4.5). If its grossmargin ratio is too low, a business typically cannot compen-sate for this serious deficiency in gross margin by cuttingother operating expenses, so its bottom line suffers. An inade-quate gross margin cascades down to the bottom line, in otherwords. Therefore investors keep a close watch for any slip-page in a company’s gross margin profit ratio. Investors andstock analysts keep a close eye on year-to-year trends in profitratios to test whether a business is able to maintain its profitmargins over time. Slippage in profit ratios is viewed withsome alarm. A business’s profit ratios are compared with itsmain competitors’ profit ratios as a way to test of the compar-ative marketing strength of the business. Higher than averageprofit ratios are often evidence that a business has developedvery strong brand names for its products or has nurturedother competitive advantages.BOOK VALUE PER SHARESuppose I tell you that the market price of a stock is $60.00per share and ask you whether this value is too high, too low,or just about right. You could compare the $60.00 marketprice with the stockholders’ equity per share reported in itsmost recent balance sheet—which is called the book value pershare. The book value per share in the business example (seeFigure 4.2) equals $31.19 ($13,188,483 total owners’ equity ÷422,823 capital stock shares = $31.19). Book value per sharehas a respectable history in securities analysis. The classicbook, Security Analysis, by Benjamin Graham and DavidDodd, puts a fair amount of weight on the book value behinda share of stock.Just the other day I read an article in the business sectionof the New York Times that was very critical of a business.Among several cogent points discussed in the article was the 49
  • 63. FINANCIAL REPORTING fact that the current market price of its stock was 29 percent below its book value. Generally speaking, the market value of stocks is higher than their book values. The reason for the comment in the article is that when a stock trades below its book value, the investors trading in the stock are of the opin- ion that the stock is not worth even its book value. But book value is backed up by the assets of the business. To illustrate this point, suppose the business in the example were to liquate all its assets at the amounts reported in its bal- ance sheet, then pay off all its liabilities, and finally distribute the money left over to its stockholders. Each share of stock would receive cash equal to the book value per share, or $31.19 per share. So book value is a theoretical liquidation value per share. From this point of view, the market value of the shares should not fall below $31.19. But the profit prospects of the business may be very dim; the stockholders may not see much chance of improving profit performance in the near future. They may think that the business could not sell off its assets at their book values and that no one would pay book value for the business as a whole. Of course, most businesses do not plan to liquidate their assets and go out of business in the foreseeable future. They plan to continue as a going concern and make a profit, at least for as far ahead as they can see. Therefore the dominant fac- tor in determining the market value of capital stock shares is the earnings potential of the business, not the book value of its ownership shares. The best place to start in assessing the earning potential of a business is its most recent earnings per- formance. Suppose I owned 10,000 capital stock shares of the busi- ness in the example and you were interested in buying my shares. What price would you offer for my shares? You’ve studied the financial statements of the business, and you pre- dict that the business will probably improve its profit perform- ance in the future. So you might be willing to pay $40, $50, or higher per share for my stock, which is based on your assess- ment of the future earnings potential of the business. Private corporations have no readily available market value informa- tion for their capital stock shares. So you’re on your own regarding what price to pay for my stock shares. Stockholders in public corporations have market value information at their fingertips, which is reported in the Wall50
  • 64. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T SStreet Journal, the New York Times, Barron’s, Investor’s Busi-ness Daily, and many other sources of financial market infor-mation. They know the prices at which buyers and sellers aretrading stocks. The main factor driving the market price of astock is its earnings per share.EARNINGS PER SHAREThe income statement presented in Figure 4.1 includes earn-ings per share (EPS), which is $3.75 for the year just ended.Privately owned businesses whose capital stock shares are nottraded in public markets do not have to report their earningsper share, and most don’t. I include it in Figure 4.1 becausepublicly owned businesses whose capital stock shares aretraded in a public marketplace (such as the New York StockExchange or Nasdaq) are required to report EPS. Earnings per share (EPS) is calculated as follows for thebusiness (see Figures 4.1 and 4.2 for data): $1,585,587 net income available for stockholdersᎏᎏᎏᎏᎏᎏᎏ422,823 total number of outstanding capital stock shares = $3.75 basic EPS For greater accuracy, the weighted average number ofshares outstanding during the year should be used to calcu-late EPS—which takes into account that some shares mayhave been issued and outstanding only part of the year. Also,a business may have reduced the number of its outstandingshares during part of the year. I use the ending number ofshares to make it easier to follow the computation of EPS. The numerator (top number) in the EPS ratio is net income available for common stockholders, whichequals bottom-line net income minus dividends paid to pre-ferred stockholders of the business. Many business corpora-tions issue preferred stock shares that require a fixed amountof dividends to be paid each year. The total of annual dividendsto the preferred stockholders is deducted from net income todetermine net income available for the common stockholders.The business in the example has issued only one class of capitalstock shares. It has not issued any preferred stock, so all its netincome is available for its common stock shares. 51
  • 65. FINANCIAL REPORTING Basic and Diluted EPS Please notice the word basic in the preceding EPS calculation. Basic means that the actual number of common stock shares in the hands of stockholders is used as the denominator (bot- tom number) for calculating EPS. If a business were to issue more shares, the denominator would become larger and EPS would decrease. The larger number of shares would dilute EPS. In fact many business corporations have entered into contracts that oblige them to issue additional stock shares in the future. These shares have not yet been issued, but the business is legally committed to issue more shares in the future. In other words, there is the potential that the number of capital stock shares will be inflated and net income will have to be divided over a larger number of stock shares. Many public businesses award their high-level managers stock options that give them the right to buy stock shares at fixed prices. These fixed purchase prices generally are set equal to the market price at the time the stock options are granted. The idea is to give the managers an incentive to improve the profit performance of the business, which should drive up the market price of its stock shares. When (and if) the market value of the stock shares rises, the managers exer- cise their rights and buy stock shares at the lower prices fixed in their option contracts. Managers can make millions of dol- lars by exercising their stock options. There is a wealth trans- fer from the nonmanagement stockholders to some of the management stockholders because the market price per share is lower than it would have been if shares had not been issued to the managers. The calculation of basic EPS does not recognize the addi-DANGER! tional shares that may be issued when management stock options are exercised in the future. Also, some businesses issue convertible bonds and convertible preferred stock that at the option of the security holders can be traded in for com- mon stock shares based on predetermined exchange rates. Conversions of senior securities into shares of common stock also cause dilution of EPS. To alert investors to the potential effects of management stock options and convertible securities, a second EPS is cal- culated by public corporations, which is called the diluted EPS. This lower EPS takes into account the effects on EPS that52
  • 66. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T Swould be caused by the issue of additional common stockshares under terms of management stock option plans andconvertible securities (plus any other commitments a businesshas entered into that requires it to issue additional stockshares in the future). Both basic EPS and diluted EPS (if appli-cable) are reported in the income statements of publiclyowned business corporations. The diluted EPS is a more con-servative figure on which to base market value.MARKET VALUE RATIOSThe capital stock shares of more than 10,000 business corpo-rations are traded on public markets—the New York StockExchange, Nasdaq, and other stock exchanges. The day-to-day market price changes of these shares receive a great dealof attention, to say the least. More than any other factor, themarket value of capital stock shares depends on the earningsper share performance of a business—its past performanceand its future profit potential. It’s difficult to prove whetherbasic EPS or diluted EPS is the driver of market value. Inmany cases the two are very close and the gap is not signifi-cant. In some cases, however, the spread between the twoEPS figures is fairly large.In addition to earnings per share (EPS) investors in stockshares of publicly owned companies closely follow two otherratios: (1) the dividend yield ratio and (2) the price/earningsratio (P/E). The dividend yield and P/E ratios are reported inthe stock trading tables published in the Wall Street Journal,which demonstrates the importance of these two market valueratios for stock shares.Dividend Yield RatioThe dividend yield ratio equals the amount of cash dividendsper share during the most recent, or trailing, 12 monthsdivided by the current market price of a stock share. The divi-dend yield ratio is the measure of cash income from a share ofstock based on its current market price. The annual return onan investment in stock shares includes both the cash divi-dends received during the period and the gain or loss in mar-ket value of the stock shares over the period. The calculation 53
  • 67. FINANCIAL REPORTING of the historical rate of return for a stock investment over two or more years and for a stock index such as the Dow Jones 30 Industrial or the Standard & Poor’s 500 assumes that cash dividends have been reinvested in additional shares of stock. Of course, individual investors may decide not to reinvest their dividends. They may spend their dividend income or put the cash flow into other investments. Price/Earnings Ratio The market price of stock shares of a public business is divided by its most recent annual EPS to determine the price/earnings ratio: Current market price of stock share ᎏᎏᎏᎏᎏᎏ Earnings per share (either basic or diluted EPS) Y = price/earning ratio, or P/E Suppose a company’s stock shares are trading at $60.00 FL per share and its EPS for the most recent year (called the trailing 12 months) is $3.00. Thus, its P/E ratio is 20. By the AM way, the Wall Street Journal uses diluted EPS to report P/E ratios in its stock trading tables. Like the other ratios dis- cussed in this chapter, the P/E ratio is compared with indus- trywide and marketwide averages to judge whether it’s too TE high or too low. I remember when a P/E ratio of 8 was typical. Today P/E ratios of 20 or higher are common. The stock shares of a privately owned business are not actively traded, and thus the market value of its shares is diffi- cult to ascertain. When shares do change hands occasionally, the price is usually kept private between the seller and buyer. Nevertheless, stockholders in these businesses are interested in what their shares are worth. To estimate the value of their stock shares, a P/E multiple can be used. In the example, the company’s EPS is $3.75 for the most recent year (see Figure 4.1). Suppose you own some of the capital stock shares and someone offers to buy your shares. You could establish an offer price at, say, 12 times basic EPS, which is $45 per share. The potential buyer may not be willing to pay this price, of course. Or he or she might be willing to pay 15 or even 18 times EPS.54
  • 68. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T SDEBT-PAYING-ABILITY RATIOSIf a business cannot pay its liabilities on time, bad things canhappen. Solvency refers to the ability of a business to pay itsliabilities when they come due. Maintaining solvency (debt-paying ability) is essential for every business. If a businessdefaults on its debt obligations it becomes vulnerable to legalproceedings by its lenders that could stop the company in itstracks, or at least seriously interfere with its normal opera-tions. Therefore, investors and lenders are very interested in thegeneral solvency and debt-paying ability of a business.Bankers and other lenders, when deciding whether to makeand renew loans to a business, direct their attention to certainsolvency ratios. These ratios provide a useful profile of thebusiness for assessing its creditworthiness and for judging theability of the business to pay its loans and interest on time.Short-Term Solvency Test: The Current RatioThe current ratio is used to test the short-term liability-payingability of a business. The current ratio is calculated by divid-ing total current assets by total current liabilities. From thedata in the company’s balance sheet (Figure 4.2), its currentratio is computed as follows: $12,742,329 current assets ᎏᎏᎏᎏ = 2.08 current ratio $6,126,096 current liabilities The current ratio is hardly ever expressed as a percent(which would be 208 percent in this case). The current ratio isstated as 2.08 to 1.00 for this company, or more simply just as2.08. The general expectation is that the current ratio for abusiness should be 2 to 1 or higher. Most businesses find thattheir creditors expect them to maintain this minimum currentratio. In other words, short-term creditors generally preferthat a business limit its current liabilities to one-half or less ofits current assets. Why do short-term creditors put this limit on a business?The main reason is to provide a safety cushion for payment ofits short-term liabilities. A current ratio of 2 to 1 means thereis $2 of cash and assets that should be converted into cashduring the near future to pay each $1 of current liabilities that 55
  • 69. FINANCIAL REPORTING come due in roughly the same time period. Each dollar of short-term liabilities is backed up with two dollars of cash on hand plus near-term cash inflows. The extra dollar of current assets provides a margin of safety. In summary, short-term sources of credit generally demand that a company’s current assets be double its current liabili- ties. After all, creditors are not owners—they don’t share in the profit success of the business. The income on their loans is limited to the interest they charge. As creditors, they quite properly minimize their loan risks; they are not compensated to take on much risk. Acid Test Ratio, or Quick Ratio Inventory is many weeks away from conversion into cash. Products usually are held two, three, or four months before being sold. If sales are made on credit, which is normal when one business sells to another business, there’s a second wait- ing period before accounts receivables are collected. In short, inventory is not nearly as liquid as accounts receivable; it takes a lot longer to convert inventory into cash. Furthermore, there’s no guarantee that all the products in inventory will be sold, or sold above cost. A more severe test of the short-term liability-paying ability of a business is the acid test ratio, which excludes inventory (and prepaid expenses also). Only cash, marketable securities investments (if the business has any), and accounts receivable are counted as sources available to pay the current liabilities of the business. This ratio is also called the quick ratio because only cash and assets quickly convertible into cash are included in the amount available for paying current liabilities. The example company’s acid test ratio is calculated as follows (the business has no investments in marketable securities): $2,345,675 cash + $3,813,582 accounts receivable ᎏᎏᎏᎏᎏᎏ $6,126,096 total current liabilities = 1.01 acid test ratio The general expectation is that a company’s acid test ratio should be 1:1 or better, although you find many more excep- tions to this rule than to the 2:1 current ratio standard.56
  • 70. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T SDebt-to-Equity RatioSome debt is good, but too much is dangerous. The debt-to-equity ratio is an indicator of whether a company is usingdebt prudently or is overburdened with debt that could causeproblems. The example company’s debt-to-equity ratio is cal-culated as follows (see Figure 4.2 for data): $13,626,096 total liabilitiesᎏᎏᎏᎏᎏ$13,188,483 total stockholders’ equity = 1.03 debt-to-equity ratioThis ratio reveals that the company is using $1.03 of liabilitiesfor each $1.00 of stockholders’ equity. Notice that all liabilities(non-interest-bearing as well as interest-bearing, and bothshort-term and long-term) are included in this ratio. Mostindustrial businesses stay below a 1 to 1 debt-to-equity ratio.They don’t want to take on too much debt, or they cannot con-vince lenders to put up more than one-half of their assets. Onthe other hand, some businesses are much more aggressiveand operate with large ratios of debt to equity. Public utilitiesand financial institutions have much higher debt-to-equityratios than 1 to 1.Times Interest EarnedTo pay interest on its debt a business needs sufficient earningsbefore interest and income tax (EBIT). To test the ability to payinterest, the times-interest-earned ratio is calculated. For theexample, annual earnings before interest and income tax isdivided by interest expense as follows (see Figure 4.1 for data):$3,234,365 earnings before interest and income taxᎏᎏᎏᎏᎏᎏ $795,000 interest expense = 4.07 times interest earnedThere is no standard guideline for this particular ratio, al-though obviously the ratio should be higher than 1 to 1. Inthis example the company’s earnings before interest andincome tax is more than four times its annual interestexpense, which is comforting from the lender’s point of view.Lenders would be very alarmed if a business barely coveredits annual interest expense. The company’s managementshould be equally alarmed, of course. 57
  • 71. FINANCIAL REPORTING ASSET TURNOVER RATIOS A business has to keep its assets busy, both to remain solvent and to be efficient in making profit. Inactive assets are an albatross around the neck of the business. Slow-moving assets can cause serious trouble. Investors and lenders use certain turnover ratios as indicators of how well a business is using its assets and to test whether some assets are sluggish and might pose a serious problem. Accounts Receivable Turnover Ratio Accounts receivable should be collected on time and not allowed to accumulate beyond the normal credit term offered to customers. To get a sense of how well the business is con- trolling its accounts receivable, the accounts receivable turn- over ratio is calculated as follows (see Figures 4.1 and 4.2 for data): $39,661,250 annual sales revenue ᎏᎏᎏᎏ = 10.4 times $3,813,582 accounts receivable The accounts receivable turnover ratio is one of the ratios published by business financial information services such as Dun & Bradstreet, Standard & Poor’s, and Moody’s. In this example, the business “turns” its customers’ receivables a lit- tle more than 10 times a year, which indicates that it waits about a tenth of a year on average to collect its receivables from credit sales. This appears reasonable, assuming that the business extends one-month credit to its customers. (A turnover of 12 would be even better.) Inventory Turnover Ratio In the business example, the company sells products. Virtually every company that sells products carries an inventory, or stockpile of products, for a period of time before the products are sold and delivered to customers. The holding period depends on the nature of business. Supermarkets have short holding periods; retail furniture stores have fairly long inven- tory holding periods. Products should not be held in inventory longer than necessary. Holding inventory is subject to several risks and accrues several costs. Products may become obsolete, may be stolen, may be damaged, or may even be misplaced.58
  • 72. I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T SProducts have to be stored, usually have to be insured, andmay have to be guarded. And the capital invested in inventoryhas a cost, of course. To get a feel for how long the business holds its inventorybefore sale, investors and lenders calculate the inventoryturnover ratio as follows (see Figures 4.1 and 4.2 for data): $24,960,750 cost-of-goods sold expense ᎏᎏᎏᎏᎏ = 4.3 times $5,760,173 inventories The inventory turnover ratio is another of the ratios pub-lished by business information service organizations. Thecompany’s 4.3 inventory turnover ratio indicates that it holdsproducts about one-fourth of a year before selling them. Theinventory turnover ratio is compared with the averages for theindustry and with previous years of the business.Asset Turnover RatioThe asset turnover ratio is a test of how well a business isusing its assets overall. This ratio is computed by dividingannual sales revenue by total assets (see Figures 4.1 and 4.2for data): $39,661,250 annual sales revenue ᎏᎏᎏᎏ = 1.5 times $26,814,579 total assetsThis ratio reveals that the business made $1.50 in sales forevery $1.00 of total assets. Conversely, the business needed$1.00 of assets to make $1.50 of sales during the year. Theratio tells us that business is relatively asset heavy. The assetturnover ratio is compared with the averages for the industryand with previous years of the business.sEND POINTIndividual investors, investment managers, stock analysts,lenders, and credit rating services commonly use the financialstatement and market value ratios explained in this chapter.Business managers use the ratios to keep watch on how theirbusiness is doing and whether there might be some troublespots that need attention. Nevertheless, the ratios are not apanacea. A financial statement ratio is like your body temperature. A 59
  • 73. FINANCIAL REPORTING normal temperature is good and means that probably nothing serious is wrong, though not necessarily. A very high or low temperature means something probably is wrong, but it takes an additional diagnosis to discover the problem. Financial statement ratios are like measures of vital signs such as your pulse rate, blood pressure, cholesterol level, body fat, and so on. Financial ratios are the vital signs of a business. There’s no end to the number of ratios than can be calcu- lated from financial statements. The trick is to focus on a rea- sonable number of ratios that have the most interpretive value. Calculating the ratios takes time. Many investors and lenders do not actually calculate the ratios. They do “eyeball tests” instead of computing ratios. They visually compare the two numbers in the ratio and do rough arithmetic in their heads to see if anything appears to be out of whack. For example, they observe that current assets are more than twice current liabilities. They do not bother to calculate the exact measure of the current ratio. This is a practical and time- saving technique as opposed to calculating ratios. Many investors and lenders use the financial statement ratios pub- lished by information service providers who compile data and information on thousands of businesses.60
  • 74. 2 PA R TAssets andSources ofCapital
  • 75. 5 CHAPTERBuilding aBalance SheetTThis chapter identifies and explains the various assets and lia-bilities used by a business in making profit. A business investsin a portfolio of operating assets and takes on certain operat-ing liabilities in the process of making sales and incurringexpenses. The main theme of the chapter is that the profit-making activities of a business (revenue and expenses) drivethe assets and liabilities that make up its balance sheet.SIZING UP TOTAL ASSETSFigure 5.1 presents an abbreviated income statement for abusiness’s most recent year. Previous chapters explain thatincome statements include more information about expensesand do not stop at the earnings before interest and income tax(EBIT) line of profit. Interest and income tax expenses arededucted to arrive at bottom-line net income. However, thecondensed and truncated income statement shown in Figure5.1 is just fine for the purpose at hand.This business example, like the examples in earlier chapters,is a hypothetical but realistic composite based on a variety offinancial reports over the years. Any particular business youlook at will differ in one or more respects from the example.Some businesses are smaller or larger than the one in theexample; their annual sales revenue may be lower or higher. 63
  • 76. A S S E T S A N D S O U R C E S O F C A P I TA L Note: Amounts are in in millions of dollars. Sales revenue $52.0 Cost-of-goods-sold expense $31.2 Gross margin $20.8 Operating expenses $16.9 Earnings before interest and income tax (EBIT) $ 3.9 FIGURE 5.1 Abbreviated income statement. The business in the example sells products, and therefore it has cost-of-goods sold expense. Many businesses sell services instead of products, and they don’t have this expense. But the example serves as a good general-purpose template that has broad applicability across many lines of businesses. Y A final comment about the example: I selected annual sales FL of $52 million as a convenient figure to work with (i.e., $1 million sales per week). This simplifies the computations in the following discussion and avoids diverting attention from AM the main points and spending too much time on number crunching. TE Two Key Questions Block by block this chapter builds the foundation of assets the business used to make sales of $52 million and to squeeze out $3.9 million profit (EBIT) from its sales revenue. Let me immediately put a question to you: What amount of total assets would you estimate that the business used in making annual sales of $52 million? Annual sales divided by total assets is called the asset turnover ratio (see Chapter 4). Indi- rectly, what I’m asking you is this: What do you think the asset turnover ratio might be for the business? The asset turnover ratios of businesses that manufacture and sell products tend to cluster in the range between 1.5 and 2.0. In other words, their annual sales revenue equals 1.5 to 2 times total assets for these kinds of businesses. To keep the arithmetic easy to follow in the discussion, assume that the64
  • 77. BUILDING A BALANCE SHEETtotal assets of the business in the example are $26 million. Soits asset turnover ratio is 2.0: ($52 million annual sales rev-enue ÷ $26 million total assets = 2.0). An asset turnover ratioof 2.0 is on the high side, but I’ll stick with it in the first partof the chapter. The second question is this: Where did the business get the $26 million invested in its assets? The moneyfor investing in assets comes from two different sources—liabilities and owners’ equity. This point is summarized in thewell-known accounting equation: Assets = liabilities + owners’ equityThe accounting equation is the basis for double-entry book-keeping. The balance sheet takes its name from the balancebetween assets on one side of the equation and liabilities plusowners’ equity on the other. The balance sheet is the financialstatement that reports a business’s assets, liabilities, and own-ers’ equity accounts.Return on AssetsThe business used $26 million total assets to earn $3.9 millionbefore interest and income tax, or EBIT. Dividing EBIT by totalassets gives the rate of return on assets (ROA) earned by thebusiness. In the example, the business earned a 15.0 percentROA for the year ($3.9 million EBIT ÷ $26 million total assets =15.0%). Is this ROA merely adequate, fairly good, or verygood? Well, relative to what benchmark or point of reference? The business has borrowed money for part of the total $26million total capital invested in its assets. The average annualinterest rate on its debt is 8.0 percent. Relative to this annualinterest rate the company’s 15.0 percent ROA is more thanadequate. Indeed, the favorable spread between these tworates works to the advantage of the business owners. Thebusiness borrows money at 8.0 percent and manages to earn15.0 percent on the money. Chapter 6 explores the veryimportant issue regarding debt versus owners’ equity assources of capital to finance the assets of a business and dis-cusses the advantages and risks of using debt capital. 65
  • 78. A S S E T S A N D S O U R C E S O F C A P I TA L This chapter deals mainly with the types and the amounts of assets needed to make profit. The non- interest-bearing operating liabilities of businesses are also included in the discussion. These short-term payables occur spontaneously when a business buys inventory on credit, receives money in advance for future delivery of products or services to customers, and delays paying for expenses. Payables arising from these sources are called spontaneous liabilities. In contrast, borrowing money from lenders and raising money from shareholders are anything but sponta- neous. Persuading lenders to loan money to the business is a protracted process, as is getting people to invest money in the business as shareowners. ASSETS AND SOURCES OF CAPITAL FOR ASSETS Continuing the example introduced previously, the business has several different assets that at year-end add up to $26 million. One of its assets is inventories, which are products being held by the business for sale to customers. These prod- ucts haven’t been sold yet, so the cost of the products is held in the asset account and will not be charged to expense until the products are sold. The cost of its inventories at year-end is $7.2 million. Of this amount, $2.4 million hadn’t been paid for by the end of the year. The business has an excellent credit rating. Its suppliers give the business a month to pay for pur- chases from them. In addition to the amounts it owes for inventory purchases, the business also has short-term liabilities of $2.6 million for unpaid operating expenses at year-end. Of its $16.9 operating expenses for the year (see Figure 5.1), $2.6 million had not been paid by the end of the year. Both types of liabilities— payables for purchases of inventory on credit and for unpaid operating expenses—are short-term, non-interest-bearing obli- gations of the business. These are called operating liabilities, or spontaneous liabilities (as mentioned). The total of these two short-term operating liabilities is $5 million in the example. To summarize, the company’s total assets, operating liabili- ties, and sources of capital for investing in its assets are shown in Figure 5.2. In Figure 5.2 note that the $5 million of operating liabilities66
  • 79. BUILDING A BALANCE SHEETNote: Amounts are in millions of dollars.Total assets $26.0 Short-term and long-term debt $ 7.5Less operating liabilities $ 5.0 Owners’ equity $13.5Capital needed for assets $21.0 Capital from debt and owners’ equity $21.0FIGURE 5.2 Summary of assets, operating liabilities, and sources of capi-tal.is deducted from total assets to determine the $21 millionamount, which is the total capital needed for investing in itsassets. I favor this layout for management analysis purposesbecause it deducts the amount of spontaneous liabilities fromthe total assets of the business. Recall that the normal operat-ing liabilities from buying things on credit and delaying pay-ment of expenses are called spontaneous because they arisein the normal process of carrying on the operations of thebusiness, not from borrowing money at interest. Operating liabilities do not bear interest (unless the busi-ness delays too long in paying these liabilities). If the businesshad paid all its operating liabilities by year-end, then its cashbalance would have been $5 million lower and its total assetswould have been $21 million. (I should mention that the busi-ness probably would not have had enough cash to pay all itsoperating liabilities before the end of the year.) A company’scash balance benefits from the float, which is the time periodthat goes by until the company pays its short-term operatingliabilities. It’s as if the business gets a $5 million interest-freeloan from its creditors.Debt versus Equity as Sources of Capital The $21 million of its assets ($26 million total assets minus the $5.0 million of its operating liabilities) isthe amount of money that the business had to obtain fromthree general sources: (1) The business borrowed money; (2)the business raised money from shareowners; and (3) thebusiness retained a good part of its annual earnings insteadof distributing all of its annual profits to shareowners. Thesethree sources of capital have provided the $21 million 67
  • 80. A S S E T S A N D S O U R C E S O F C A P I TA L invested in its assets. Of this total capital, $7.5 million is from short-term and longer-term debt sources. The rest of the com- pany’s total capital is from owners’ equity, which consists of the amounts invested by shareowners over the years plus the accumulated retained earnings of the business. Figure 5.2 does not differentiate between the cumulative amounts invested by shareowners and the retained earnings of the business—only the total $13.5 million for owners’ equity is shown in Figure 5.2. Interest is the cost of using debt capital, of course. In con- trast, a business does not make a contractual promise to pay shareowners a predetermined amount or a percent of distri- bution from profit each year. Rather, the cost of equity capital is an imputed cost, equal to a sought-after amount of net income that the business should earn annually relative to the owners’ equity employed in the business. The owners’ equity is $13.5 million of the company’s $21 million total capital. Shareowners expect the business to earn annual net income on owners’ equity that is higher than the interest rate on its debt. Shareowners take more risk than lenders. Assume, therefore, that the business’s objective is to earn a 15.0 per- cent or higher annual net income on owners’ equity. In the example, therefore, net income should be at least $2,025,000 ($13.5 million owners’ equity × 15.0% = $2,025,000 net income benchmark). A company’s actual earnings before interest and income tax (EBIT) for a year may not be enough to pay interest on its debt capital, pay income tax, and achieve its after-tax net income objective relative to owners’ equity. What about this example, for instance? The business made $3.9 million EBIT, as reported in Figure 5.1. The annual interest rate on its debt was 8.0 percent, as mentioned earlier. So, its annual interest expense was $600,000 ($7.5 million total debt × 8.0% annual interest rate = $600,000). So the business made $3.3 million earnings after interest and before income tax. Its income tax rate is 34 percent of this amount. Thus, its income tax is $1,122,000 and its net income, or earnings after interest and income tax, is $2,178,000. The business achieved its goal of earning 15.0 percent or better of net income on owners’ equity ($2,178,000 net income ÷ $13,500,000 owners’ equity = 16.1%). The shareowners may be satisfied with this 16.1 percent return on68
  • 81. BUILDING A BALANCE SHEETtheir capital, or they may insist that the business should dobetter. Chapter 6 explores the strategy of using debt to enhancenet income performance (as well as the risks of using debtcapital, which a business may or may not be willing to take).The rest of this chapter focuses on the assets and operatingliabilities that are driven by the profit-making activities of abusiness. A large chunk of a company’s balance sheet (state-ment of financial condition) consists of these assets and oper-ating liabilities. CONNECTING SALES REVENUE AND EXPENSES WITH OPERATING ASSETS AND LIABILITIESFigure 5.3 shows the lines of connection from sales revenueand expenses to the company’s respective assets and operat-ing liabilities. (The foregoing business example is continued inthis section.) The assets and operating liabilities shown in Fig-ure 5.3 are explained briefly as follows:• Making sales on credit causes a business to record accounts receivable.Note: Amounts are in millions of dollars. Income Statement AssetsSales revenue $52.0 Accounts receivableCost-of-goods-sold expense $31.2 InventoriesGross margin $20.8 Prepaid expensesOperating expenses $16.9 Property, plant, and equipmentEarnings before interest andincome tax (EBIT) $ 3.9 Operating Liabilities Accounts payable Accrued expenses payableFIGURE 5.3 Operating assets and liabilities driven by sales revenue andexpenses. 69
  • 82. A S S E T S A N D S O U R C E S O F C A P I TA L • Acquiring and holding products before they are sold to cus- tomers causes a business to record inventories. • The costs of some operating expenses are paid before the cost is recorded as an expense, which causes a business to record prepaid expenses. • Investments in long-term operating resources, called prop- erty, plant, and equipment (or, more informally, fixed assets), cause a business to record depreciation expense that is included in operating expenses. • Inventory purchases on credit cause a business to record accounts payable. • Many expenses are recorded before they are paid, which causes a business to record its unpaid expense amounts in either an accounts payable account or an accrued expenses payable account. These two payables are called operating liabilities. Accounts Receivable No dollar amounts (also called balances) are shown for the assets and operating liabilities in Figure 5.3. The amounts depend on the policies and practices of the business. The amount of the accounts receivable asset depends on the credit terms offered to the company’s customers, whether most of the customers pay their bills on time, and how many cus- tomers are delinquent. For example, assume the business offers its customers one-month credit, which most take, but the company’s actual collection experience is closer to five weeks, on average, because some customers pay late. In this situation the balance of its accounts receivable would be about five weeks of annual sales revenue, or approximately $5 mil- lion at the end of the year ($52 million annual sales revenue × 5/52 = approximately $5 million accounts receivable). Inventories The amount of the company’s inventories asset depends on the company’s holding period—the time from acquisition of products until the products are sold and delivered to cus- tomers. Suppose that, on average, across all products sold, the business holds products in inventory about 12 weeks. In this70
  • 83. BUILDING A BALANCE SHEETsituation the company’s year-end inventory would be about$7.2 million ($31.2 annual cost-of-goods-sold expense ×12/52 = approximately $7.2 million). At the end of the year,recent acquisitions of inventory had not been paid for becausethe company buys on credit from the sources of products. See the line of connection in Figure 5.3 from the invento-ries asset to accounts payable. Assume, for instance, thatabout one-third of its ending inventories had not been paidfor. As a result, the year-end accounts payable would be about$2.4 million from inventory purchases on credit. The totalamount of accounts payable also includes the amount ofunpaid expenses of the business at the end of the year forwhich the business has been billed by its vendors.Operating LiabilitiesFor most businesses, a sizable amount of operating expensesrecorded during the latter part of a year are not paid by theend of the year. At the end of the year the business has unpaidbills from its utility company for gas and electricity, from itslawyers for work done during recent weeks, from the tele-phone company, from maintenance and repair vendors, andso on. A business records the amounts it has been billed for(received an invoice for) in the accounts payable operating lia-bility account. A business also has a second and equallyimportant type of operating liability. A business has manyexpenses that accumulate, or accrue over time, for which itdoes not receive bills, and to record these “creeping” expensesa business uses a second type of operating liability accountthat is discussed next.In my experience, business managers and investors do notappreciate the rather large size of accruals for various operat-ing expenses. Many operating expenses are not on a pay-as-you-go basis. For example, accumulated vacation and sickleave benefits are not paid until the employees actually taketheir vacations and sick days. At year-end, the company calcu-lates profit-sharing bonuses and other profit-sharing amounts,which are recorded as expense in the period just ended, eventhough they will not be paid until some time later. Productwarranty and guarantee costs should be accrued and chargedto expense so that these follow-up costs are recognized in the 71
  • 84. A S S E T S A N D S O U R C E S O F C A P I TA L same year that sales revenue is recorded—to get a correct matching of sales revenue and expenses to measure profit. In summary, a surprising number of expense accruals are recorded. Expense accruals are recorded in a separate account, labeled accrued expenses payable in Figure 5.3, because they are quite different than accounts payable. For one thing, an account payable is based on an actual invoice received by the vendor, whereas accruals have no such hard copy that serves as evidence of the liability. Accruals depend much more on good faith estimates of the accountants and others making these calculations. Suppose the business in the example knows from experience that the balance of this operating lia- bility tends to be about five weeks of its annual total operating expenses. This ratio of accrued expenses payable to annual operating expenses is based on the types of accruals that the company records, such as accrued vacation and sick pay for employees, accrued property taxes, accrued warranty and guarantee costs on products, and so on. The five weeks reflects the aver- age time between when these expenses are recorded and when they are actually paid, which can be quite a long time for some items but rather short for others. Thus, the year-end balance of the company’s accrued expenses payable liability account is about $1.6 million ($16.9 million annual operating expenses × 5/52 = approximately $1.6 million). Prepaid Expenses, Fixed Assets, and Depreciation Expense Chapter 2 explains the accrual basis of profit accounting and cash flow from profit. One key point to keep in mind in com- paring profit and cash flow is that a business has to prepay some of its operating expenses. I won’t repeat that discussion here; I’ll simply piggyback on the discussion and point out that a business has an asset account called prepaid expenses, which holds the prepaid cost amounts that have not been charged off to expense by the end of the year. Usually, the amount of the prepaid expenses asset account is relatively small—although, if the ending balance were large compared with a company’s annual operating expenses, this strange72
  • 85. BUILDING A BALANCE SHEETstate of affairs definitely should be investigated. A businessmanager should notice an unusually large balance in the pre-paid expenses and demand an explanation. One of the operating expenses of a business is depreciation.This is a very unique expense, especially from the cash flowpoint of view (as Chapter 2 discusses at some length). I do notseparate depreciation expense in Figure 5.3, although I doshow a line of connection from the company’s fixed assetsaccount (property, plant, and equipment) to operatingexpenses. As I explain in Chapter 2, the original cost of fixedassets is spread over the years of their use according to anallocation method.What about Cash?A business has one other asset not shown in Figure 5.3 ormentioned so far—cash. Every business needs a working cashbalance. Recall that in the example the company’s annualsales revenue is $52 million, or $1 million per week on aver-age. But the actual cash collections in a given week could beconsiderably less or much more than the $1 million average.A business can’t live hand to mouth and wait for actual cashcollections to arrive before it writes checks. Employees haveto be paid on time, of course, and a business can’t ask itscreditors to wait for payment until it collects enough moneyfrom its customers. In short, a business maintains a minimum cash balance asa safety buffer. Many businesses keep rather large cash bal-ances, part of which usually is invested in safe, short-termmarketable debt securities on which the business earns inter-est income. The average cash balance of a business relative toits annual sales revenue may be very low or fairly high. Cashbalance policies vary widely from business to business. If Ihad to guess the cash balance of the business in the example,I would put it at around two or three weeks of annual salesrevenue, or about $2 to $3 million. But I wouldn’t be sur-prised if its cash balance were outside this range. There’s no doubt that every business needs to keep enoughcash in its checking account (or on hand in currency and coinfor cash-based businesses such as grocery stores and gamblingcasinos). But precisely how much? Every business manager 73
  • 86. A S S E T S A N D S O U R C E S O F C A P I TA L would worry if cash were too low to meet the next payroll. Some liabilities can be put off for days or even weeks, but employees have to be paid on time. Beyond a minimum, rock- bottom cash balance amount to meet the payroll and to pro- vide at least a bare-bones margin of safety, it is not clear how much additional cash balance a business should carry, just as some people may have only $5 or $10 in walking-around money and others could reach in their wallet and pull out $500. Unnecessary excess cash balances should be avoided. Excess cash is an unproductive asset that doesn’t pay its way toward meeting the company’s cost of capital (i.e., the interest on debt capital and the net income that should be earned on equity capital). For another thing, excess cash balances can cause managers to become lax in controlling expenses. Money in the bank, waiting only for a check to be written, is often an incen- Y tive to make unnecessary expenditures, not scrutinizing them FL as closely as needed. Also, excess cash balances can lead to greater opportunities for fraud and embezzlement. Yet having a large cash balance is a tremendous advantage AM in some situations. The business may be able to drive a hard bargain with a major vendor by paying cash up front rather than asking for the normal credit terms. There are many TE such reasons for holding a cash balance over and above what’s really needed to meet payroll and to provide for a safety buffer for the normal lags and leads in the cash receipts and cash disbursements of the company. Frankly, if this were my business I would want at least a three weeks’ cash balance. An executive of a leading company said he kept the com- pany’s cash balance “lean and mean” to keep its managers on their toes. There’s probably a lot of truth in this. But if too much time and effort goes into managing day-to-day cash flow, then the more important strategic factors may not be managed well. Figure 5.3 does not present a complete picture of the com- pany’s financial condition. Cash is missing, as just discussed, and the sources of the company’s capital are not shown. It’s time to fill in the remaining pieces of the statement of finan- cial condition of the business, otherwise known as the balance sheet.74
  • 87. BUILDING A BALANCE SHEETBALANCE SHEET TETHERED WITH INCOMESTATEMENTFigure 5.4 presents the income statement and balance sheet(statement of financial condition) for the business example.The income statement includes interest expense, income taxexpense, and net income (which are discussed earlier in thechapter). The balance sheet includes the sources of capitalthat the business has tapped to invest in its assets—interest-bearing debt and owners’ equity. The balance sheet is pre-sented according to the discussion earlier in the chapter. Inparticular, note that the total amount of operating liabilities(the sum of accounts payable and accrued expenses payable)is deducted from total assets to determine the capital investedin assets.Note: Amounts are in millions of dollars.Income Statement Balance Sheet Assets Cash $ 3.0 Accounts receivable $ 5.0 Inventories $ 7.2 Prepaid expenses $ 1.0 Property, plant, andSales revenue $52.0 equipment $17.5Cost-of-goods-sold expense $31.2 Accumulated depreciation ($ 7.7) $ 9.8Gross margin $20.8 Total assets $26.0Operating expenses $16.9Earnings before interest Operating Liabilities and income tax $ 3.9Interest expense $ 0.6 Accounts payable $ 3.4Earnings before income tax $ 3.3 Accrued expenses payable $ 1.6 $ 5.0Income tax expense $ 1.1 Capital invested in assets $21.0Net income $ 2.2 Sources of Capital Interest-bearing debt $ 7.5 Owners’ equity $13.5 Total sources of capital $21.0FIGURE 5.4 Balance sheet and income statement. 75
  • 88. A S S E T S A N D S O U R C E S O F C A P I TA L Figure 5.4 displays lines of connection, or tether lines, from sales revenue and expenses in the income statement to their corresponding assets and operating liabili- ties in the balance sheet. These lines are not actually shown in financial reports, of course. I include them in Figure 5.4 to stress that the profit-making activities of a business drive a good part of its balance sheet. Also, you might note the line from net income to owners’ equity; net income increases the owners’ equity. All or part of annual net income may be dis- tributed in cash to its shareowners, which is recorded as a decrease in the business’s owners’ equity.s END POINT A business needs assets to make profit. Therefore a business must raise capital for the money to invest in its assets. The seed capital comes from shareowners; they may invest addi- tional money in the business from time to time after the busi- ness gets off the ground. Most businesses borrow money on the basis of interest-bearing debt instruments such as notes payable. Profitable businesses retain part or all of their annual earnings to supplement the money invested in the business by their shareowners. The balance sheet, or statement of financial condition, reports the debt and equity capital sources of a business and the assets in which the business has invested. Several differ- ent types of assets are listed in the balance sheet. The balance sheet also reports the operating liabilities of a business that are generated by its profit-making activities and not from bor- rowing money. Operating liabilities are non-interest-bearing payables of a business, which are quite different from its interest-bearing debt obligations. The relationships of sales revenue and expenses reported in a company’s income statement to the assets and operating liabilities reported in its balance sheet are not haphazard. Far from it! Sales revenue and the different expenses in the income statement match up with particular assets and operat- ing liabilities. Business managers, lenders, and investors should understand these critical connections between the components of the income statement and the components of the balance sheet. In particular, the amount of accounts76
  • 89. BUILDING A BALANCE SHEETreceivable should be reasonable in comparison with annualsales revenue, and the amount of inventories should be rea-sonable in comparison with annual cost-of-goods-soldexpense. In short, the balance sheet of a business fits tongue andgroove with its income statement. These two financial state-ments are presented separately in financial reports, but busi-ness managers, lenders, and investors should understand theinterlocking nature of these two primary financial statements. 77
  • 90. 6 CHAPTERBusiness CapitalSourcesTThis chapter explores the two basic sources of business capi-tal: debt and owners’ equity. Every business must make a fun-damental decision regarding how to finance the business,which refers to the mix or relative proportions of debt andequity. By borrowing money, a business enlarges its equitycapital, so the business has a bigger base of capital to carryon its profit-making activities. More capital generally means abusiness can make more sales, and more sales generallymean more profit. Using debt in addition to equity capital is referred to as financial leverage. If you visualize equity capitalas the fulcrum, then debt may be seen as the lever that servesto expand the total capital of a business. The chapter explainsthe gain or loss resulting from financial leverage, which oftenis a major factor in bottom-line profit.It’s possible, I suppose, to find a business that is so antidebtthat the only liabilities it has are normal operating liabilities(i.e., accounts payable and accrued expenses payable). These short-term liabilities arise spontaneously in makingpurchases on credit and from delaying the payment of certainexpenses until sometime after the expenses have been 79
  • 91. A S S E T S A N D S O U R C E S O F C A P I TA L recorded. A business can hardly avoid operating liabilities. But a business doesn’t have to borrow money. A business could possibly raise all the capital it needs from shareowners and from retaining all or a good part of its annual earnings in the business. In short, a business theoretically could rely entirely on equity capital and have no debt at all—but this way of financing a business is very rare indeed. BUSINESS EXAMPLE FOR THIS CHAPTER Figure 6.1 presents a very condensed balance sheet and an abbreviated income statement for a new business example. The income statement is truncated at earnings before interest and income tax (EBIT). The two financial statements in Figure 6.1 are telescoped into a few lines. In this chapter we don’t need all the details that are actually reported in these two financial statements. (See Figure 4.2 for the full format of a balance sheet and Figure 4.1 for a typical format of an exter- nal income statement.) To support its $18.5 million annual sales, the business used $11.5 million total assets. Operating liabilities provided $1.5 million of its assets. In Figure 6.1 the company’s operating lia- bilities are deducted from its total assets to get a very impor- tant figure—capital invested in assets. The business had to raise $10 million in capital from debt and owners’ equity. The business borrows money on the basis of short-term and long- term notes payable. The business built up its owners’ equity Balance Sheet Income Statement Assets used in making profit $11,500,000 Sales revenue $18,500,000 Operating liabilities All operating (accounts payable and expenses ($16,700,000) accrued expenses payable) ($ 1,500,000) Earnings before Capital invested in assets $10,000,000 interest and income Debt and equity sources of tax expenses (EBIT) $ 1,800,000 capital $10,000,000 FIGURE 6.1 Condensed financial statements.80
  • 92. B U S I N E S S C A P I TA L S O U R C E Sfrom money invested by shareowners plus the cumulativeamount of retained earnings over the years (undistributed netincome year after year).Once Again Quickly: Assetsand Operating Liabilities Chapter 5 explains that a business that sells products on credit needs four main assets in making profit: cash, accounts receivable, inventories, and long-livedresources such as land, buildings, machinery, and equipmentthat are referred to as fixed assets (or, more formally, as prop-erty, plant, and equipment). The chapter goes into the charac-teristics of each asset, explaining how sales revenue andexpenses are connected with these assets. Chapter 5 alsoexplains how expenses drive the operating liabilities of a busi-ness. In the process of making profit a business generates cer-tain short-term, non-interest-bearing operating liabilities thatare inseparable from its profit-making transactions. Thesepayables of a business are called spontaneous liabilities becauseoperating activities, not borrowing money, causes them. Oper-ating liabilities are deducted from total assets to determine theamount of capital that has been raised by a business.CAPITAL STRUCTURE OF BUSINESSThe capital a business needs for investing in its assets comesfrom two basic sources: debt and equity. Managers must con-vince lenders to loan money to the company and convincesources of equity capital to invest their money in the company.Both debt and equity sources demand to be compensated forthe use of their capital. Interest is paid on debt and reportedin the income statement as an expense, which like all expensesis deducted from sales revenue to determine bottom-line netincome. In contrast, no charge or deduction for using equitycapital is reported in the income statement.Rather, net income is reported as the reward or payoff onequity capital. In other words, profit is defined from theshareowners point of view, not from the total capital point ofview. Interest is treated not as a division of profit to one of thetwo sources of capital of the business but as an expense, and 81
  • 93. A S S E T S A N D S O U R C E S O F C A P I TA L profit is defined to be the residual amount after deducting interest. Sometimes the owners’ equity of a business is referred to as its net worth. The fundamental idea of net worth is this: Net worth = assets − operating liabilities − debt Net income increases the net worth of a business. The busi- ness is better off earning net income, because its net worth increases by the net income amount. Suppose another group of investors stands ready to buy the business for a total price equal to its net worth. This offering price, or market value, of the business increases by the amount of net income. Cash dis- tributions of net income to shareowners decrease the net worth of a business, because cash decreases with no corre- sponding decrease in the operating liabilities or debt of the business. The amounts of cash distributions from net income are reported in the statement of cash flows, which is explained in Chapter 2. Dividends are also reported in a separate state- ment of changes in owners’ equity accounts if this particular schedule is included in a financial report (see Figure 4.4 for an example). The valuation of a business is not so simple as someone buying the business for an amount equal to its net worth. Business valuation usually takes into account the net worth reported in its balance sheet, but many other factors play a role in putting a value on a business. The amount a buyer is willing to offer for a business can be considerably higher than the company’s net worth based on the figures reported in the company’s most recent balance sheet. The valuation of a pri- vately owned business is quite a broad topic, which is beyond the scope of this book. Likewise, the valuation of stock shares of publicly owned business corporations is a far-reaching topic beyond the confines of this book. At its most recent year-end, the business had $10 million invested in assets to carry on its profit-making operations (total assets less its operating liabilities). Suppose that debt has provided $4 million of the total capital invested in assets and owners’ equity has supplied the other $6 million. Collec- tively, the mix of these two capital sources are referred to as the capitalization or the capital structure of the business. Be82
  • 94. B U S I N E S S C A P I TA L S O U R C E Scareful about the term capitalization: Similar terms meansomething different. The terms market capitalization, marketcap, or cap refer to the total market value of a publicly tradedcorporation, which is equal to the current market price pershare of stock times the total number of stock shares out-standing (in the hands of stockholders). A perpetual question that’s not easy to answer concernswhether a business is using the optimal or best capital struc-ture. Perhaps the business in the example should have carriedmore debt. Maybe the company could have gotten by on asmaller cash balance, say $500,000 less—which means that$500,000 less capital would have been needed. Perhaps thebusiness should have kept its accounts receivable and inven-tory balances lower, which would have reduced the need forcapital. Every business has to make tough choices regardingdebt versus equity, asking shareowners for more money ver-sus retaining earnings, and working with a lean working cashbalance versus a larger and more comfortable cash balance.The answers to these questions are seldom easy and clear cut.Basic Characteristics of DebtDebt may be very short term, which generally means sixmonths or less, or it may be long term, which generally means10 years or longer—or for any period mutually agreed onbetween the business and its lender. The term debt meansinterest-bearing in all cases. Interest rates can be fixed overthe life of the debt contract or subject to change, usually at thelender’s option. On short-term debt, interest usually is paid atthe end of the loan period. On long-term debt, interest usuallyis paid monthly or quarterly (sometimes semiannually). A key feature of debt is whether the principal of the loan (the amount borrowed) is amortized over thelife of the loan instead of being paid at the end of the loanperiod. In addition to paying interest, the business (who is theborrower, or debtor) may be required to make payments peri-odically that reduce the principal balance of the debt insteadof waiting until the final maturity date to pay off the entireprincipal amount at one time. For example, a loan may callfor equal quarterly amounts over five years. Each quarterly 83
  • 95. A S S E T S A N D S O U R C E S O F C A P I TA L payment is calculated to pay interest and to reduce a part of the principal balance so that at the end of the five years the loan principal will be paid off. Alternatively, the business may negotiate a term loan. Nothing is paid to reduce the principal balance during the life of a term loan; the entire amount bor- rowed (the principal) is paid at the maturity date of the loan. The lender may demand that certain assets of the business be pledged as collateral. The lender would be granted the right to take control of the property in the event the business defaults on the loan. Real estate (land and buildings) is the most common type of collateral, and these types of loans are called mortgages. Inventory and other assets also serve as col- lateral on some business loans. Debt instruments such as bonds may have very restrictive covenants (conditions) or, conversely, may be quite liberal and nonbinding on the busi- ness. Some debt is convertible into equity stock shares, though generally this feature is limited to publicly held corpo- Y rations whose stock shares are actively traded. The debt of a FL business may be a private loan, or debt securities may be issued to the public at large and be actively traded on a bond market. AM Lenders look over the shoulders of the managers of the business. Lenders do not simply say, “Here’s the money and call us if you need more.” A business does not exactly have to TE bare its soul when applying for a loan, but the lender usually demands a lot of information from the business. If a business defaults on a loan (not making an interest payment on time or not being able to pay off the loan at maturity), the terms of the loan give the lender legally enforceable options that in the extreme could force the business into bankruptcy. If a busi- ness does not comply fully with the terms and provisions of its loans, it is more or less at the mercy of its lenders, which could cause serious disruptions or even force the business to terminate its operations. Basic Characteristics of Equity One person may operate a business as the sole proprietor and provide all the equity capital of the business. A sole propri- etorship business is not a separate legal entity; it’s an exten- sion of the individual. Many businesses are legally organized as a partnership of two or more persons. A partnership is a84
  • 96. B U S I N E S S C A P I TA L S O U R C E Sseparate entity or person in the eyes of the law. The generalpartners of the business can be held responsible for the liabili-ties of the partnership. Creditors can reach beyond the assetsof the partnership to the personal assets of the individualpartners to satisfy their claims against the business. The gen-eral partners have unlimited liability for the liabilities of thepartnership. Some partnerships have two classes of partners—general and limited. Limited partners escape the unlimitedliability of general partners but they have no voice in the man-agement of the business.Most businesses, even relatively small ones, favor the corpo-rate form of organization. A corporation is a legal entity sepa-rate from its individual owners. A corporation is a legal entitythat shields the personal assets of the owners (the stockhold-ers, or shareowners) from the creditors of the business. Abusiness may deliberately defraud its creditors and attempt toabuse the limited liability of corporate shareowners. In thiscase the law will “pierce the corporate veil” and hold theguilty individuals responsible for the debts of the business. The corporate form is a practical way to collect a pool ofequity capital from a large number of investors. There are lit-erally millions of corporations in the American economy. In1997 the Internal Revenue Service received over 4.7 milliontax returns from business corporations. Most were small busi-nesses. However, more than 860,000 businesses corporationshad annual sales revenue over $1 million.Other countries around the globe have the equivalent of cor-porations, although the names of these organizations as wellas their legal and political features differ from country tocountry. A recent development in the United States is the cre-ation of a new type of business legal entity called a limited lia-bility company (LLC). This innovative business entity is ahybrid between a partnership and a corporation; it has char-acteristics of both. Most states have passed laws enabling thecreation of LLCs. Corporations issue capital stock shares; these are the unitsof equity ownership in the business. A corporation may issueonly one class of stock shares, called common stock or capitalstock. Or a corporation may issue both preferred stock andcommon stock shares. Preferred stock shares are promised an 85
  • 97. A S S E T S A N D S O U R C E S O F C A P I TA L annual cash dividend per share. (The actual payment of the dividend is contingent on the corporation earning enough net income and having enough cash on hand to pay the dividend.) A corporation may issue both voting and nonvoting classes of stock shares. Some corporations issue two classes of voting shares that have different voting power per share (e.g., one class may have ten votes per share and the other only one vote per share). Debt bears an explicit and legally contracted rate of inter- est. Equity capital does not. Nevertheless, equity capital has an imputed or implicit cost. Management must earn a satis- factory rate of earnings on the equity capital of the business to justify the use of this capital. Failure to do so reduces the value of the equity and makes it more difficult to attract addi- tional equity capital (if and when needed). In extreme circum- stances, the majority of stockholders could vote to dissolve the corporation and force the business to liquidate its assets, pay off its liabilities, and distribute the remainder to the stock- holders. The equity shareholders in a business (the stockholders ofDANGER! a corporation) take the risk of business failure and poor performance. On the optimistic side, the shareowners have no limit on their participation in the success of the business. Continued growth can lead to continued growth in cash divi- dends. And the market value of the equity shares has no theo- retical upper limit. The lower limit of market value is zero (the shares become worthless)—although corporate stock shares could be assessable, which means the corporation has the right to assess shareholders and make them contribute addi- tional capital to the organization. Almost all corporate stock shares are issued as nonassessable shares, although equity investors in a business can’t be too careful about this. RETURN ON INVESTMENT I was a stockholder in a privately owned business a few years ago. I owned 1,000 shares of common stock in the business and served on its board of directors. One thing really hit home. I came to appreciate firsthand that we (the stockholders) had a lot of money invested, and we expected the business to do well with our money. We could have invested our money elsewhere and received interest income or earned some other type of86
  • 98. B U S I N E S S C A P I TA L S O U R C E Sreturn on our alternative investment. Management was verymuch aware that their responsibility was to improve the valueof our stock shares over time, which would require that thebusiness earn a good return on our investment. The basic measure for evaluating the performance of capital investments is the return on investment(ROI), which always is expressed as a percent. To calculateROI, the amount of return is divided by the amount of capitalinvested: return ROI% = ᎏᎏ capital invested ROI is always for a given period of time—one year unlessclearly stated otherwise. Return is a generic term and meansdifferent things for different investments. For investments inmarketable securities, return includes cash income receivedduring the period and the increase or decrease in marketvalue during the period. The ROI on an investment in mar-ketable securities is negative if the decrease in market value ismore than the cash income received during the period. Market value is not a factor for some investments. Oneexample is an investment in a certificate of deposit (CD) issuedby a financial institution. Return equals just the interestearned. A CD is not traded in a public market place and hasno market value. The value of a CD is the amount the financialinstitution will redeem it for at the maturity date, which is theface value on which interest is based. In the event that thefinancial institution doesn’t redeem the CD at full value atmaturity, the investor suffers a loss that could wipe out part orall of the interest earned on the CD. (CDs are guaranteed up toa certain limit by an agency of the federal government, butthat’s another matter.) Real estate investments may or may not include marketvalue appreciation in accounting for annual earnings, depend-ing on whether market prices of the real estate properties canbe reliably estimated or appraised at the end of each period. Ifmarket value changes are not booked, the return on a realestate investment venture is not known until the conclusion ofthe investment project. Evaluating the investment performance of a business usesthree different measures: (1) return on assets (ROA), (2) 87
  • 99. A S S E T S A N D S O U R C E S O F C A P I TA L interest rate, and (3) return on equity (ROE). Figure 6.2 illus- trates the calculations of these three key rates of return for the business introduced earlier. The example assumes that the business has $4 million debt capital and $6 million equity capital. (Different mixes of debt and equity capital are examined later.) The definitions for each rate of return are as follows: • ROA = earnings before interest and income tax expenses, or EBIT ÷ (assets − operating liabilities) • Interest rate = interest expense ÷ interest bearing debt • ROE = net income ÷ owners’ equity Figure 6.2 is a capital structure model that can be used to analyze alternative scenarios such as a different debt-to- equity ratio, a higher or lower ROA performance, or a differ- ent interest rate. Figure 6.2 is the printout of a relatively simple personal computer worksheet. Different numbers can easily be plugged into the appropriate cell for one or more of the variables in the model in order to see how net income and the ROE would be affected. Alternative scenarios are exam- ined later in the chapter using the capital structure model. Sales revenue less all operating expenses equals earnings before interest and income tax (EBIT). As shown in Figure 6.2, EBIT is divided three ways: (1) interest on debt capital, (2) income tax, keeping in mind that interest is deductible to Earnings before Assets less Return on interest and operating assets income tax (EBIT) $1,800,000 ÷ liabilities $10,000,000 = 18.0% (ROA) Interest expense ($ 300,000) ÷ Debt $ 4,000,000 = 7.5% Interest rate Income tax expense @ 40% of taxable income ($ 600,000) Government Owners’ Return on Net income $ 900,000 ÷ equity $ 6,000,000 = 15.0% equity (ROE) FIGURE 6.2 Rates of return on assets, debt, and equity.88
  • 100. B U S I N E S S C A P I TA L S O U R C E Sdetermine taxable income, and (3) residual net income. Inother words, the debt holders get a chunk of EBIT (interest),the federal and state governments get their chunks (incometax), and what’s left over is profit for the shareowners of thebusiness (net income). Note that the ROA rate and the interestrate are before income tax, whereas ROE is after income tax.The income tax factor is in the middle of things in more waysthan one. PIVOTAL ROLE OF INCOME TAX In a world without income taxes, EBIT would bedivided between the two capital sources—interest on debt andnet income for the equity owners (the stockholders of a corpo-ration). But in the real world income tax takes a big bite out ofearnings after interest. In the example, the combined federaland state income tax rate is set at 40 percent of taxableincome. As you probably know, interest expense is deductedfrom EBIT to determine taxable income ($1.8 million EBIT −$300,000 interest = $1.5 million taxable income; $1.5 milliontaxable income × 40% combined federal and state income taxrate = $600,000 income tax). The following question might be asked: Should income taxbe considered a return on government capital investment? Thefederal and state governments do not directly invest capital ina business, of course. In a broader sense, however, govern-ment provides what can be called public capital. Governmentprovides public facilities (highways, parks, schools, etc.), politi-cal stability, the monetary system, the legal system, and policeprotection. In short, government provides the necessary infra-structure for carrying on business activity, and governmentfunds this through income taxes and other taxes. Under the federal income tax law (U.S. Internal RevenueCode), interest on debt is deductible in determining annualtaxable income. Cash dividends paid to stockholders—whichcan be viewed as the equity equivalent of interest on debt—are not deductible in determining taxable income. This basicdifferentiation in the tax law has significant impact on theamount of EBIT needed to earn a satisfactory ROE on theequity capital of a business. The business in the example needs to earn just $300,000EBIT for its $300,000 interest. The $300,000 EBIT minus 89
  • 101. A S S E T S A N D S O U R C E S O F C A P I TA L $300,000 interest leaves zero taxable income and thus no income tax. In contrast, to earn $900,000 after-tax net income on equity, the business needs $1.5 million EBIT: $900,000 net income $900,000 ᎏᎏᎏ = ᎏᎏ = $1,500,000 EBIT 1 − 40% income tax rate 0.60 Income tax takes $600,000 of the $1,500,000 earnings after interest, leaving $900,000 net income after income tax. Suppose for the moment that interest were not deductible to determine taxable income. In this imaginary income tax world the business would need $500,000 EBIT to cover its $300,000 interest. Income tax at the 40 percent rate would be $200,000 on this $500,000 EBIT, leaving $300,000 after tax to pay interest. The business would need $500,000 EBIT for interest and $1.5 million EBIT for net income, for a total of $2 Notes on Income TaxT The company example uses a 40 percent combined federal and state income tax rate, which is realistic. However, the taxation of business income varies considerably from state to state. Also, under the current federal income tax law, corporate taxable income from $335,000 to $10 million is taxed at a 34 percent rate. Annual taxable incomes below $335,000 are taxed at lower rates and above $10 million at a slightly higher rate. The example assumes that the business is a corporation and is taxed as a domestic C (or regular) corporation. A corporation with 75 or fewer stockholders may elect to be treated as an S cor- poration. An S corporation pays no income tax itself; its annual taxable income is passed through to its individual stockholders in proportion to their ownership share. Sole proprietorships, partnerships, and limited liability companies are also tax con- duits; they are not subject to income tax as separate entities but pass their taxable income through to their owner or owners who have to include their shares of the entity’s taxable income in their personal income tax returns. Individual situations vary widely, as you know. Corporations may have net loss carryforwards that reduce or eliminate taxable income in one year. There is also the alternative minimum tax (AMT) to consider, to say nothing of a myriad of other provisions and options (loopholes) in the tax law. It’s very difficult to generalize. The main point is that in a given year in a given situation the taxable income of the business may not result in a normal amount of income tax.90
  • 102. B U S I N E S S C A P I TA L S O U R C E S million EBIT. The business would have to have earned a 20.0 percent ROA rate in this situation. But since interest is deductible, the business needed to earn only 18.0 percent ROA to pay interest and to generate 15.0 percent ROE for its shareowners. RETURN ON EQUITY (ROE) The example business is organized as a corporation. The company’s shareowners invested money in the business for which they received shares of capital stock issued by the busi- ness. Keep in mind that the stockholders could have invested this money elsewhere. The business over the years retained a good amount of its annual net income instead of distributing all its annual net income as cash dividends to its stockholders. The total owners’ equity capital of the business from both sources is $6.0 million. This amount includes the paid-in capi- tal invested in the business by its stockholders and the cumu- lative amount of retained earnings. Stockholders’ equity capital is at risk; the business may orDANGER! may not be able to earn an adequate net income for its stockholders every year. For that matter, the company could go belly-up and into bankruptcy. In bankruptcy proceedings, stockholders are paid last, after all debts and liabilities are set- tled. There’s no promise that cash dividends will be paid to stockholders even if the business earns net income. The ROE ratio does not consider what portion (if any) of the business’s annual net income was distributed as cash dividends. The entire net income figure is used to compute the ROE ratio. In the example (see Figure 6.2), the company’s ROE was 15.0 percent for the year, which is not terrific but not too bad. This comment raises a larger question regarding which yard- stick is most relevant. Theoretically, the $6 million owners’ equity in the business could be pulled out and invested some- where else to earn a return on the best alternative investment. Should the company’s ROE be compared with the rate of return that could be earned on a riskless and highly liquid investment such as short-term U.S. government securities? Surely not. Everyone agrees that a company’s ROE should be compared with comparable investment alternatives that have the same risk and liquidity characteristics as stockholders’ equity. 91
  • 103. A S S E T S A N D S O U R C E S O F C A P I TA L The rate of return on the most relevant alternative (the next best investment alternative) is called the opportunity cost of capital. To avoid a prolonged discussion, simply assume that the stockholders want the business to improve on its 15.0 percent ROE performance. This implies that their opportunity cost of capital is higher than 15.0 per- cent, at least in the minds of the stockholders. Of course, the company should maintain its ROE and do even better if possi- ble. One reason for the business’s ROE being as good as it is that the company had a nice gain from financial leverage. FINANCIAL LEVERAGE Piling debt on top of equity capital is called financial leverage. As stated at the beginning of the chapter, if you visu- alize equity capital as the fulcrum, then debt may be seen as the lever that serves to expand the total capital of a business. For this reason, using debt is also called trading on the equity. The main advantage of debt is that a business has more capi- tal to work with and is not limited to the amount of equity capital that a business can muster. The larger capital base can be used to crank out more sales, which should yield more profit. Of course, this assumes that the business can actually make profit from using its capital. Using debt also has another important potential advantage. If a business borrows money at an interest rate that is lower than its ROA rate, it makes a financial leverage gain. The idea is to borrow at a relatively low rate, earn a relatively high rate, and keep the difference. In Figure 6.2, note that the company earns 18.0 percent ROA but paid only 7.5 percent interest on its borrowed capital. (The business has several loans and pays different interest rates on each loan; the 7.5 percent is its composite average interest rate.) You don’t have to be a rocket scientist to figure out that paying 7.5 percent for money and earning 18.0 percent on it is a good deal. In the example, debt provides 40 percent of the capital invested in assets ($4 million of the total $10 million). Thus, 40 percent of the company’s EBIT is attributable to its debt capital ($1.8 million EBIT × 40% = $720,000). But the busi- ness paid only $300,000 interest expense for the use of the92
  • 104. B U S I N E S S C A P I TA L S O U R C E Sdebt capital. Therefore its gain is the excess, or $420,000($720,000 debt’s share of EBIT − $300,000 interest =$420,000 financial leverage gain). Another way to computethe gain from financial leverage is to multiply the 10.5 percentspread between the 18.0 percent ROA earned by the businessand its 7.5 percent interest rate times the amount of its debt(10.5% spread × $4 million debt = $420,000 financial leveragegain before income tax). A financial leverage gain adds to the share of EBIT avail-able for equity capital. Figure 6.3 illustrates the importance ofthe financial leverage gain in the company’s profit perform-ance for the year. Using debt provides additional earnings forthe equity investors in the business. The shareowners earnEBIT on their capital in the business and also get the overflowof EBIT on debt capital after paying interest. In the example,financial leverage gain contributes a good share of the earn-ings for shareowners, as shown in Figure 6.3. The financialleverage gain adds 39 percent on top of EBIT earned onequity capital ($420,000 financial leverage gain ÷ $1,080,000EBIT on equity capital = 39%).In analyzing profit performance, managers should separatetwo components of earnings before income tax: (1) the finan-cial leverage gain and (2) the EBIT earned on owners’ equitycapital. As shown in Figure 6.3, the company’s $1.5 millionearnings before income tax consists of $420,000 financial debt percent debt share$1,800,000 EBIT × 40% of total capital = $ 720,000 of EBIT ($ 300,000) interest financial $ 420,000 leverage gain equity percent equity share$1,800,000 EBIT × 60% of total capital = $1,080,000 of EBIT earnings for equity $1,500,000 before income taxFIGURE 6.3 Components of earnings for equity. 93
  • 105. A S S E T S A N D S O U R C E S O F C A P I TA L leverage gain plus the $1,080,000 pretax EBIT on equity capi- tal. Therefore, a good part of the company’s pretax profit is sensitive to the interest rate on its debt and its ratio of debt to equity. If its interest rate had been 18.0 percent (an unreason- ably high interest rate these days) the financial leverage gain would have been zero. The business, by using a moderate amount of debt capital, enhanced the earnings for its owners. Professor Ron Melicher, my longtime colleague at the University of Colorado, calls this the earnings multiplier effect. I very much like this term to describe the effects of financial leverage. The financial lever- age multiplier effect cuts both ways, however. A percentage drop in the company’s ROA causes earnings for equity to drop by a larger percentage. Why not borrow to the hilt in order to maximize financial leverage gain? Well, for one thing, the amount of debt that can be borrowed is limited. Lenders will loan only so much money Y to a business, relative to its assets and its sales revenue and FL profit history. Once a business hits its borrowing capacity, more debt is either not available or interest rates and other lending terms become prohibitive. Furthermore, there are AM several disadvantages of debt. The deeper lenders are into the business the more restric-DANGER! tions they impose on the business, such as limiting cash TE dividends to shareowners and insisting that the business maintain minimum cash balances. Lenders may demand more collateral for their loans as the debt load of a business increases. Also, there is the threat that the lender may not renew the loans. Some businesses end up too top-heavy with debt and can’t make their interest payments on time or pay their loans at maturity and the lender is not willing to renew the loan. These businesses may be forced into bankruptcy in an attempt to work out their debt problems. In short, using debt capital has many risks. Interest rates change over time and the ROA rate earned by a business could plunge, even below its interest rate. Even relatively small changes in the ROA and interest rates can have a sub- stantial impact on earnings. It’s no surprise that many busi- nesses are quite debt-averse, opting for low levels of debt even though they could carry more. The company in the example uses a fair amount of debt; using either more or less debt would have caused more or less financial leverage gain.94
  • 106. B U S I N E S S C A P I TA L S O U R C E SsEND POINTEvery business must decide on a blend of debt and equity cap-ital to invest in the assets it needs to make a profit. The totalcapital invested in assets should be no more than necessary.Interest has to be paid on debt capital, and the businessshould earn at least a satisfactory return on equity capital inorder to survive and thrive. The starting point is to earn anadequate return on assets (ROA), that is, an adequate amountof earnings before interest and income tax (EBIT) relative tothe total capital invested in assets. Operating liabilities (mainlyaccounts payable and accrued expenses payable) are deductedfrom total assets to determine the amount of capital investedin assets. Using debt enlarges the total capital base of a business, andwith more capital a business can make more sales and gener-ate more profit. Using debt for part of the total capital investedin assets offers the opportunity to benefit from financial lever-age—as well as the risk of suffering a financial leverage loss ifthe business does not earn an ROA rate greater than the inter-est rate on its debt. Managers should measure the financialleverage gain or loss component of earnings for shareowners.The financial leverage gain or loss component of earnings issensitive to changes in the interest rate, the debt level, andthe ROA of the business. 95
  • 107. 7 CHAPTERCapital Needsof GrowthIIn this chapter we return to the business example introducedin Chapter 3 and whose external financial statements areinterpreted in Chapter 4. The business’s financial perform-ance for the year just ended was satisfactory at best. Forinstance, the business’s profit ratio on sales (bottom-line netincome divided by sales revenue) was just 4.0 percent. Itslackluster profit ratio resulted in a return on equity (ROE) ofonly 12.0 percent. Its shareowners have made it clear that thebusiness should do better than this. Later chapters explain analysis tools and strategies for improving profit. This chapter starts with theprofit improvement plan for the coming year that has beendeveloped by the business. The chapter focuses on the addi-tional amount of capital that the business will need to carryout its profit improvement plan. The main theme of the chap-ter is this: Profit planning also requires capital planning.Managers cannot simply assume that the needed capital willbecome available like manna from heaven. They should deter-mine how much additional capital would be needed to supportprofit growth and they should plan for the sources of the newcapital. 97
  • 108. A S S E T S A N D S O U R C E S O F C A P I TA L PROFIT GROWTH PLAN The business has developed an ambitious profit improvement plan for the coming year. Sales goals have been established for virtually every product the business sells. Sales pricing will be more aggressive. (The very important effects of changes in sales volume and sales price are examined in later chapters.) Adver- tising and sales promotion programs have been approved. Cost control will be a top priority in the coming year. To replace its old machines, equipment, tools, and vehicles the board of directors has approved a capital expenditures budget for the coming year. The business is optimistic that it can achieve its profit and return on equity goals for the coming year. Figure 7.1 summarizes the company’s profit plan for the coming year. Actual results for the year just ended are shown for comparison, as well as the percent increases over the year just ended. Note that interest expense has a question mark after it. At this point the exact amount of debt for the coming year is not known. The business will need to increase its assets to support the higher sales level next year, which means it will need more capital to invest in its assets. Some of the additional capital may come from increasing its debt—by borrowing more money from its lenders. Clearly, the amount of the business’s debt will not decrease given the planned increase in sales revenue. So the interest expense for the year just ended is carried forward for the coming year Year Just Coming Ended Year Change Sales revenue $39,661,250 $45,857,625 +15.6% Cost-of-goods-sold expense $24,960,750 $28,589,255 +14.5% Gross margin $14,700,500 $17,268,370 +17.5% Variable and fixed operating expenses $11,466,135 $12,675,896 +10.6% Earnings before interest and income tax $ 3,234,365 $ 4,592,474 +42.0% Interest expense $ 795,000 $ 795,000 ? + 0.0% Earnings before income tax $ 2,439,365 $ 3,797,474 +55.7% Income tax expense $ 853,778 $ 1,329,116 +55.7% Net income $ 1,585,587 $ 2,468,358 +55.7% FIGURE 7.1 Profit improvement plan for coming year.98
  • 109. C A P I TA L N E E D S O F G R O W T H until more is known about the amount of capital that the com- pany will raise from external sources during the coming year. The final numbers below the earnings before interest and income tax (EBIT) line would be revised if the level of debt were increased. However, this last-minute adjustment shouldn’t be very material. As Figure 7.1 shows, the business has put together an overall plan for the coming year that would increase its bottom-line profit 55.7 percent over the year just ended, which is impres- sive. However, the profit plan, standing alone, does not reveal the amount of additional capital that will be needed for the increase in assets at the higher level of sales. Sales growth requires more assets to support the higher level of sales rev- enue and expenses. It would be very unusual to achieve sales growth without increasing assets. Sales growth needs to gen- erate enough profit growth to cover the cost of the additional capital needed for the higher level of assets. PLANNING ASSETS AND CAPITAL GROWTH At the close of the business’s most recent year, which is the starting point for the coming year of course, the capital invested in its assets and the sources of the capital are as follows (data is from the company’s balance sheet presented in Figure 4.2): Total assets $26,814,579 Less operating liabilities $ 3,876,096 Capital invested in assets $22,938,483 Short-term and long-term debt $ 9,750,000 Owners’ equity $13,188,483 Total sources of capital $22,938,483 A Please recall that operating liabilities (mainly accountsRemember payable and accrued expenses payable) are generated spontaneously from making purchases on credit and from unpaid expenses. These short-term liabilities are non-interest- bearing and are deducted from total assets to determine the 99
  • 110. A S S E T S A N D S O U R C E S O F C A P I TA L amount of capital invested in assets. This capital has to be secured from borrowing and from owners’ equity sources. A Very Quick But Simplistic Method According to the company’s profit improvement plan for the coming year (Figure 7.1), sales revenue is scheduled to increase 15.6 percent. The business could simply assume that its total assets and operating liabilities would increase the same per- cent. This calculation yields about a $3.5 million increase in the capital invested in assets (total assets less operating liabili- ties). Based on this figure the business could anticipate, say, a $1 million increase in debt and a $2.5 million increase in owners’ equity. (At an 8.0 percent annual interest rate the interest expense for the coming year would increase $80,000, and the interest and income tax expenses would be adjusted accordingly.) This expedient but overly simplistic method for forecasting assets and capital growth has serious shortcomings: • It assumes that sales revenue drives assets and operating liabilities when in fact only accounts receivable is driven directly by sales revenue; expenses drive the other short- term operating assets and short-term operating liabilities. • It ignores the actual amount of capital expenditures planned for the coming year; the total investment in new long-term operating resources during a particular year does not move in lockstep with changes in sales revenue that year. • It does not identify the amount of cash flow from profit dur- ing the coming year; in most situations this internal source of cash flow provides a sizable amount of the capital for increasing the assets of the business, which alleviates the need to go to external sources of capital. The business should match up the increases in sales rev- enue and expenses with the particular operating assets and liabilities that are driven by the sales revenue and expenses. Then the amount of capital expenditures planned for the com- ing year should be factored into the analysis, as well as the planned increase or decrease in the company’s working cash balance (more on this shortly).100
  • 111. C A P I TA L N E E D S O F G R O W T H Finally, the business should include the cash flow from profit (operating activities) during the comingyear in planning the sources of its total capital needs duringthe coming year. Cash flow from profit during the coming yearprobably would not provide all the capital needed for growth,but usually provides a good share of it. Managers have toknow the amount of internal capital that will be generatedfrom profit so they know the additional amount of capital theywill have to raise from external sources in order to fuel thegrowth of the business.A Fairly Quick and Much MoreSophisticated MethodOne method for determining changes in assets and liabilitiesfor the coming year and for planning where to get the addi-tional capital for the higher level of assets in the coming yearis to use a formal and comprehensive budget system. As youprobably know, budgeting systems are time-consuming andsomewhat costly—although for management planning andcontrol purposes the time and money may be well spent.Many businesses, even some fairly large ones, do not usebudgeting systems. But, they still have to plan for the impend-ing capital needs to support the growth of the business. This section demonstrates a method for planning assetsand capital growth based on the profit improvement plan ofthe business, one that can be done fairly quickly and thatavoids all the trappings of a detailed budgeting systemapproach. The first step is to forecast the changes in assetsand operating liabilities during the coming year—see Figure7.2. The balance sheet format is used, starting with the clos-ing balances from the year just ended, which are the startingbalances for the coming year. Increases in sales revenue and expenses planned for thecoming year drive many of the increases in assets and operat-ing liabilities, as shown in Figure 7.2. The amounts of theincreases in short-term operating assets and liabilities arecomputed based on the changes in sales revenue andexpenses for the coming year in the profit improvement plan.The actual changes in each of these operating assets and lia-bilities in all likelihood would deviate from these estimates, 101
  • 112. A S S E T S A N D S O U R C E S O F C A P I TA L Assets Based on Profit Improvement Beginning Plan and Balances (from Planning Figure 4.2) Decisions Change Cash $ 2,345,675 Note 1 $ 200,000 Accounts receivable $ 3,813,582 15.6% $ 594,919 Inventories $ 5,760,173 14.5% $ 835,225 Prepaid expenses $ 822,899 10.6% $ 87,227 Total current assets $12,742,329 Property, plant, and equipment $20,857,500 Note 2 $3,000,000 Accumulated depreciation ($ 6,785,250) Note 3 ($ 943,450) Cost less accumulated depreciation $14,072,250 Total assets $26,814,579 Liabilities and Owners’ Equity Accounts payable $ 2,537,232 Note 4 $ 325,108 Accrued expenses payable $ 1,280,214 10.6% $ 135,703 Income tax payable $ 58,650 Note 5 $ 0 Short-term debt $ 2,250,000 Total current liabilities $ 6,126,096 Long-term debt $ 7,500,000 Total liabilities $13,626,096 Capital stock (422,823 and 420,208 shares) $ 4,587,500 Retained earnings $ 8,600,983 Note 6 $1,868,358 Total owners’ equity $13,188,483 Total liabilities and owners’ equity $26,814,579 FIGURE 7.2 Increases in assets, liabilities, and retained earnings. but probably not by too much—unless the business were to change its basic policies regarding credit terms it offers its customers, its average inventory holding periods, and so on. To complete the picture the business has to make certain planning decisions for the coming year. These key planning decisions concern capital expenditures, whether to increase its working cash balance, and whether to pay out cash dividends102
  • 113. C A P I TA L N E E D S O F G R O W T Hto shareowners. Also the amount of depreciation that will berecorded in the coming year needs to be calculated. These keypoints are summarized as follows:Planning Decisions for Coming Year• Note 1. The business prefers to increase its working cash balance at least $200,000 to keep pace with the increase in sales growth. At the end of the most recent year its cash balance was about $2.3 million. I discuss in other chapters that there is no standard or generally agreed upon ratio of the working cash balance of a business relative to its annual sales or total assets or any other point of reference. This business plans to increase its sales revenue in the coming year to about $46 million (Figure 7.1). Whether a $2.3 million working cash balance is sufficient for $46 mil- lion annual sales is a matter of opinion. Many businesses would be comfortable with this balance, but many would not. This business believes that it should increase its work- ing cash balance at least $200,000, which is shown in Fig- ure 7.2.• Note 2. Based on a thorough study of the condition, pro- ductivity, and capacity of its fixed assets, the business has adopted a $3 million budget for capital expenditures during the coming year. (Usually, the board of directors of a busi- ness must approve major capital outlays for investments in new long-term operating assets.) The decision regarding when to replace such items as old machines, equipment, vehicles, tools is seldom clear-cut and obvious. As a rough comparison, these business decisions are similar to decid- ing when to replace your old high-mileage auto with a new model. Many factors enter into the decisions regarding replacing old fixed assets of a business with newer models that may be more efficient and reliable, or that are needed to expand the capacity of the business.• Note 3. Depreciation expense increases the accumulated depreciation account, which is a contra, or negative, account. Its balance is deducted from the fixed assets account in which the original cost of property, plant, and equipment is recorded. An increase in the accumulated depreciation account means that its negative balance 103
  • 114. A S S E T S A N D S O U R C E S O F C A P I TA L becomes larger. The amount of depreciation expense for the coming year will be higher than last year because new fixed assets costing $3 million will be purchased during the year. The accounting department calculates the amount of depreciation expense that will be recorded during the com- ing year. Recording depreciation expense does not require a cash outlay during the year—just the opposite in fact. The cash inflow from sales revenue includes recovery of part of the original cost of the business’s long-term operating resources (recorded in the property, plant, and equipment account). Therefore the amount of depreciation expense recorded during a year is added to net income for calculating cash flow from profit for the coming year. (There are other cash flow adjustments to net income as well.) • Note 4. Inventories will increase 14.5 percent, so accounts payable from inventory purchases on credit should increase Y this percent. Also, the accounts payable liability account FL includes expenses recorded in the period and that are still unpaid at the end of the period. This component should increase 10.6 percent, which is equal to the percent AM increase in operating expenses for the coming year. The increase in accounts payable includes both components. • Note 5. Income tax payable may change during the coming TE year; in any case the increase or decrease is likely to be rel- atively minor, so a zero change is entered for this liability. • Note 6. Net income planned for the coming year equals $2,468,358 according to the profit improvement plan (Fig- ure 7.1). The board of directors would like to pay $600,000 cash dividends to shareowners during the coming year. Therefore retained earnings would increase $1,868,358 ($2,468,358 net income − $600,000 cash dividends to shareowners). The forecast changes in operating assets, liabilities, and retained earnings that are presented in Figure 7.2 provide the essential information for determining the internal cash flow from profit for the coming year. Cash flow from profit may not be all the capital needed for growth, however. The business probably will have to go to its external sources for additional capital. Cash flow from profit (operating activities) during the coming104
  • 115. C A P I TA L N E E D S O F G R O W T Hyear is based on the profit improvement plan and theincreases in operating assets and liabilities forecast for thecoming year. The first section in Figure 7.3 calculates cashflow from profit, which is then compared with the demandsfor capital during the coming year. In this way the amount ofadditional capital from external sources is determined. The business will have to raise almost $1.5 million in exter-nal capital during the coming year ($1,444,752, to be moreexact). The business’s chief executive working with the chieffinancial officer will have to decide whether to approachlenders to increase the debt load of the business and whetherthe business should turn to its shareowners and ask them toinvest additional capital in the business. Of course, these arenot easy decisions. The information in Figure 7.3 is the indis-pensable starting point.sEND POINTGrowth is the central strategy of many businesses. Growthrequires that additional capital be secured to provide money Cash flow from profit (operating activities)Net income planned for coming year $2,468,358Accounts receivable increase ($ 594,919)Inventories increase ($ 835,225)Prepaid expenses increase ($ 87,227)Depreciation expense $ 943,450Accounts payable increase $ 325,108Accrued expenses payable increase $ 135,703 $2,355,248 Demands for capitalIncrease in working cash balance $ 200,000Capital expenditures budget $3,000,000Cash dividends to shareowners $ 600,000 $3,800,000External capital needed during coming year $1,444,752*Figures 7.1 and 7.2 are sources of above data.FIGURE 7.3 Cash flow from profit and external capital needed. 105
  • 116. A S S E T S A N D S O U R C E S O F C A P I TA L for the increases in operating assets needed to support the higher sales level. Growth penalizes cash flow from profit to some extent. Generally speaking, a business cannot depend only on its internal cash flow from profit to supply all the capi- tal needed for increasing its assets, and therefore it must go to outside sources of capital. Based on the profit improvement plan for a business, the chapter demonstrates an efficient and practical method for forecasting the amount of capital needed to fuel the growth of the business and how much will have to come from its exter- nal capital sources in addition to its projected cash flow from profit for the coming year.106
  • 117. 3 PA R TProfit and CashFlow Analysis
  • 118. 8 CHAPTERBreaking Even andMaking ProfitSSuccessful companies are those who year in and year out earnsufficient profit before interest and income tax from theiroperations. Operating earnings is the litmus test of all success-ful businesses. How do they do it? Not just by making salesbut also by controlling their expenses so that they keepenough of their sales revenue as operating profit. The long-term sustainable success of a business rests on the ability ofits managers to earn operating profit consistently. Managersmust know well the pathways to operating profit and avoiddetours along the way.ADDING INFORMATION IN THE MANAGEMENTPROFIT REPORTThe main business example used in previous chapters is con-tinued in this chapter. Figure 8.1 presents the company’smanagement profit report for the year just ended—withimportant new information presented here for the first time.The design of this internal accounting profit report copies theformat introduced in Chapter 3. The new items of informationare as follows:• Total sales volume (number of units) of all products sold during the period• The average sales revenue per unit (average sales price per unit) 109
  • 119. PROFIT AND CASH FLOW ANALYSIS Sales Volume 578,500 Units Per Unit Totals Sales revenue $68.56 $39,661,250 Cost-of-goods-sold expense ($43.15) ($24,960,750) Gross margin $25.41 $14,700,500 Variable revenue-driven operating expenses ($ 5.27) ($ 3,049,010) Variable unit-driven operating expenses ($ 4.63) ($ 2,677,875) Contribution margin $15.51 $ 8,973,615 Fixed operating expenses ($ 5,739,250) Operating profit $ 3,234,365 Interest expense ($ 795,000) Earnings before income tax $ 2,439,365 Income tax expense ($ 853,778) Net income $ 1,585,587 FIGURE 8.1 Management profit report for year just ended, including sales volume and per-unit values. • The average product cost per unit (average cost of goods sold per unit) • The average variable operating expenses per unit (revenue- driven and unit-driven) This additional information is needed for the profit analysis methods explained in this chapter. The business has three major product lines and sells dif- ferent products within each line. The business sells a fairly large number of different products, which is typical of most businesses. This chapter looks at the business as a whole, from the viewpoint of its top executives and board of direc- tors. The chapter does not probe into profit margin differ- ences between the business’s product lines and separate products within each product line. These topics are discussed in later chapters. For measuring overall sales activity, businesses in many industries adopt a common denominator that cuts across all the products sold by the business. Examples are barrels for110
  • 120. BREAKING EVEN AND MAKING PROFITbreweries, tons for steel mills, passenger miles for airlines,and vehicles for car and truck manufacturers. The sales volume for the year reported in Figure 8.1 is thesum of all units sold during the year. Per-unit values in thismanagement profit report are averages for all products. Ofcourse, the averages depend on the sales mix of products dur-ing the year, which refers to the relative proportions of eachproduct sold. Changes in a business’s sales mix can cause sig-nificant changes in the average sales price and average costs,which can cause a major shift in profit. These important points are explored in Chapter 17. In thischapter it does no harm to pretend that the company sells justone product. This one product serves as a stand-in, or proxy,for all the products sold by the company. The business sold578,500 units at a $68.56 sales price; product cost was $43.15;and the company incurred $5.27 revenue-driven variable costsand $4.63 unit-driven variable costs for each unit sold. There-fore, the business earned $15.51 contribution margin per unitsold (Figure 8.1). This profit margin figure equals sales priceminus product cost minus the two variable operating expenses. The business sold 578,500 units at this margin per unit, soit earned $8,973,615 contribution margin ($15.51 contribu-tion margin per unit × 578,500 units sales volume =$8,973,615 contribution margin). This measure of profit isbefore fixed operating expenses for the year and before inter-est and income tax expenses. Of course, contribution marginis not the bottom-line profit of a business. But it is anextremely important stepping-stone measure of profit thatdeserves close management attention.Although not shown in Figure 8.1, contribution margin equals22.6 percent of sales revenue ($8,973,615 contribution mar-gin ÷ $39,661,250 sales revenue = 22.6%). Managers shouldcompare this key ratio with prior years and against the com-pany’s profit objectives for the year just ended. Any slippagein this important ratio can have serious consequences, aslater chapters demonstrate. This chapter focuses on how thebusiness made the amount of profit that it did for the year.Later chapters focus on changes in sales volume, sales prices,cost changes, and other factors that improve or damage profitperformance. 111
  • 121. PROFIT AND CASH FLOW ANALYSIS FIXED OPERATING EXPENSES Fixed operating expenses are deducted from contri- bution margin to determine operating profit, which also is called operating earnings, or earnings before interest and income tax (EBIT). The general nature of fixed costs is explained in Chapter 3. A business has many operating expenses that vary either with sales volume or with sales rev- enue. In stark contrast, a business has many operating expenses that do not vary with sales activity. Instead these costs remain stuck in place over a range of sales activity levels. Examples of typical fixed operating expenses are the fol- lowing. A business signs annual or multiyear lease contracts for retail and warehouse space; the monthly rents are fixed in amount and do not depend on the sales of the business. Employees are hired and paid fixed salaries per month or are promised 40-hour weeks at certain hourly rates. Premiums are paid for six months to provide insurance coverage against casualty and liability losses. Utility and telephone bills are paid monthly and do not depend on sales levels. Property taxes and vehicle licenses are fixed amounts for the year. Many other examples of fixed operating costs could be listed. In short, a business makes many commitments that incur certain operating costs for a period of time. These fixed costs cannot be avoided unless the business takes drastic action, such as breaking contracts, firing employees, or not paying property taxes. For all practical purposes, fixed operating expenses are pretty much locked in for the year. Fixed operat- ing expenses often are called overhead costs because these costs hang over the head of the managers running the busi- ness like an albatross or millstone. Why would any rational manager commit to overhead costs? Fixed operating expenses provide capacity. These costs make available the capacity to carry on sales activity and other operations of the business. Fixed expenses are incurred to provide the needed space, equipment, and personnel to sell products and to carry on the necessary operating activities of the business. By committing to these costs, the business acquires a certain amount of capacity, or ability to operate for the period. Business managers should estimate the sales capacity of their business (i.e., the maximum sales volume that is feasible112
  • 122. BREAKING EVEN AND MAKING PROFITbased on the fixed expenses of the business). Estimating salescapacity may not be all that precise, but a reasonable, ball-park estimate can be made. The manager could start by ask-ing whether a 10 percent sales volume increase would requirean increase in the business’s fixed expenses. Managers shouldcompare the business’s sales capacity against actual sales vol-ume. A business may have a large amount of unused salescapacity. Perhaps sales could grow 10, 20, or 30 percentbefore more space would have to be rented and more personswould have to be hired or more equipment would have to beinstalled. Having an estimate of the idle, unused sales capacityof the business is especially important in planning ahead andin analyzing the profit impact of changes in the key factorsthat drive profit, as the following discussion reveals.The term fixed should be used with caution. True, the fixedcosts of a business for a period are largely unchanging andinflexible—but not down to the last penny. The main pointabout fixed operating expenses is that they are insensitive tothe number of units sold during the period or the amount ofsales revenue for the period—unless a business takes drasticaction to scale down or expand its sales capacity. Many, if notmost, fixed expenses can be adjusted if sales drop off precipi-tously or surge ahead rapidly. For example, suppose salestake a sudden and unexpected downturn. A business couldsublet part of the space it rents, reduce insurance limits, orsell some of the property it owns. If on the other hand salesspurted up all of a sudden, a business could ask its employeeswho are guaranteed a 40-hour workweek at a fixed hourlyrate to work overtime to handle the upsurge in sales. Whatthe term fixed actually means is that these costs remainlargely constant in the short run over a range of sales activitythat might be 10 to 25 percent lower or higher than the actualsales volume of the business.DEPRECIATION: A SPECIAL KIND OF FIXED COSTDepreciation expense accounting is unique; you could evensay weird. The basic idea of allocating the cost of a long-termoperating resource over its useful, productive life is sound andunimpeachable. (Ownership of land confers the right tooccupy a certain space in perpetuity, so the cost of land is not 113
  • 123. PROFIT AND CASH FLOW ANALYSIS depreciated.) The total cost of a company’s long-term operat- ing resources is reported in an asset account in its balance sheet, usually entitled property, plant, and equipment. The original costs of fixed assets are recorded in one account, and depreciation expense each period is recorded in a second account called accumulated depreciation. The balance in this contra, or offset, account is the cumulative amount of depreciation expense recorded to date. Its balance is deducted from the property, plant, and equipment asset account. In this way the balance sheet discloses both the cost of a company’s fixed assets and how much of the cost has been depreciated so far. For instance, at the close of its most recent year the busi- ness’s fixed assets are reported as follows in its year-end bal- ance sheet (from Figure 4.2): Y FL Property, plant, and equipment $20,857,500 Accumulated depreciation ($ 6,785,250) AM Cost less accumulated depreciation $14,072,250 TE In this example the business’s fixed operating expenses for the year just ended include $768,450 depreciation expense. In other words, the business recorded a $768,450 write-off of its fixed assets in order to recognize the wear and tear on and the gradual loss of productivity of its long-term operating resources. In short, the year just ended was charged more than three-quarters of a million dollars for the use of fixed assets during the year. But, the amount of depreciation expense for the year should be taken with a grain of salt. Indeed, you need a saltshaker in the case of depreciation. Business managers should pay particular attention to the depreciation expense accounting methods used by their busi- ness for three main reasons: 1. Depreciation expense is not a cash outlay in the year it is recorded; the fixed assets being depreciated were bought and paid for in previous years (except for the new fixed assets acquired during the most recent year).114
  • 124. BREAKING EVEN AND MAKING PROFIT2. The computation of annual depreciation expense is based on an arbitrary time-based method of allocation—not on the actual level of use of fixed assets during the period.3. For the vast majority of businesses, the amount of annual depreciation expense is determined by federal income tax—the useful lives permitted under the tax law are con- siderably shorter than realistic estimates for most fixed assets of most businesses; and the income tax law permits front-end loading of depreciation expense (except for buildings), which causes the expense to decline from year to year.As a practical matter, most businesses use the useful lives fortheir fixed assets that are permitted by the federal income taxlaw, and they use one of the allocation methods allowed by thelaw. Most businesses abandon any attempt to base deprecia-tion on realistic useful life estimates and actual patterns of usefrom year to year. One result is that a fixed asset, say a partic-ular piece of machinery or equipment, could be fully depreci-ated on the books yet continue to be used for severaladditional years during which no depreciation expense isrecorded. Business managers definitely should know whethercertain of their operating fixed assets were used during theperiod for which no depreciation expense was recorded. In times past there was an argument for the units-of-production depreciation method for manufacturers. Themethod, in brief, works as follows. The business estimates thetotal number of units expected to be manufactured using aparticular machine or piece of equipment over its entire eco-nomic life. This number is divided into cost of the fixed assetto calculate depreciation per unit. The amount of depreciationrecorded for the period depends on the number of units man-ufactured. Depreciation would be a variable cost if this methodwere used. The units-of-production depreciation method is seldom ifever used—even though it has good theoretical support.Instead businesses’ fixed assets are depreciated by either thestraight-line method or an accelerated method. Both methodsallocate a certain predetermined amount of a fixed asset’s costto each year of the estimated life of the asset regardless ofhow much or how little the asset actually might be used dur-ing the year. Therefore, depreciation is a fixed cost. 115
  • 125. PROFIT AND CASH FLOW ANALYSIS INTEREST EXPENSE The business incurred $795,000 interest expense for the year just ended (Figure 8.1). Interest is not an operating expense— it’s a financial expense. As you know, interest is the cost of using debt for part of the total capital invested in the assets of the business. Generally speaking, the total amount of capital invested in assets swings up and down with shifts in sales revenue—though certainly not in direct proportion to changes in sales revenue or sales volume (number of units sold). Thus the amount of debt tends to move in the same direction as changes in sales. However, the linkage between shifts in sales revenue and debt is not simple and cannot easily be put into a formula. For relatively minor swings in its sales level a business probably would not adjust the amount of its debt in most situ- ations, so its interest expense would remain fixed in amount. On the other hand, for major shifts in sales a business proba- bly would adjust the amount of its debt, so its interest expense would change. In the following analysis assume that the busi- ness’s annual interest expense is fixed—keeping in mind that a major change in sales volume probably would result in a corresponding change in debt and interest expense. PATHWAYS TO PROFIT The business’s operating profit, earnings before income tax, and net income are presented in the management profit report (Figure 8.1). Reading a profit report is passive and reflective; computing profit is active and engaging. Managers don’t get paid to know profit, but to make profit happen. Man- agers need a sure-handed analytical grip on the factors that drive profit. The following discussion explains methods of cal- culating profit, mainly for the purpose of demonstrating how profit is earned. Before calculating profit it’s necessary to identify which particular profit definition is being used: oper- ating profit (earnings before interest and income tax), earn- ings before income tax (earnings after interest expense), or bottom-line net income (earnings after income tax). Income116
  • 126. BREAKING EVEN AND MAKING PROFITtax is a contingent expense; basically it’s a certain percent oftaxable income. Taxable income, generally speaking, equalsearnings before income tax because interest expense isdeductible to determine taxable income. (Tax accountants willcringe when they read this sentence because there are manycomplexities in the federal income tax law; but to simplify Iassume that taxable income equals the business’s earningsbefore income tax.) In the example, the business’s income taxrate is 35 percent of its earnings before income tax. In the following analysis the business’s fixed operatingexpenses and its fixed interest expense are combined into onetotal fixed cost for the year ($5,739,250 fixed operatingexpenses + $795,000 fixed interest expense = $6,534,250 totalfixed costs). In other words, profit is defined as earningsbefore income tax. The business earned $2,439,365 profit forthe year just ended (Figure 8.1). There are three different ways to analyze how the businessearned its profit for the year, and each offers valuable lessonsfor business managers.Pathway to Profit #1: Margin Times Sales VolumeOne pathway for calculating profit is as follows (data is fromFigure 8.1): $15.51 contribution margin per unit × 578,500 total units sold (sales volume) = $8,973,615 total contribution margin − $6,534,250 fixed expenses = $2,439,365 profitTechnical note: Contribution margin per unit shown here is arounded figure; the precise contribution margin per unit isused in calculating total contribution margin. The linchpin in this computation is the multiplication ofcontribution margin per unit by sales volume to get total con-tribution margin. Sales volume needs a good contributionmargin per unit to work with. Maybe you’ve heard the oldjoke: “A business loses a little on each sale but makes it upon volume.” This isn’t funny, you know. 117
  • 127. PROFIT AND CASH FLOW ANALYSIS The Breakeven Hurdle The business sold enough units to overcome its fixed expenses and earn a profit. Business managers worry a lot about their fixed costs—there’s no profit unless the business’s sales volume is large enough to cover its fixed expenses. The sales volume needed to cover fixed costs is called the breakeven point, or the breakeven volume, or more simply just breakeven. The breakeven point equals that exact sales volume at which total contribution margin equals total fixed expenses. The breakeven calculation tells a manager the sales volume that has to be achieved just to cover his or her fixed costs for the year. Generally, businesses do not publicly divulge their breakeven volumes. Financial reporting standards do not require that this particular piece of information be disclosed in external financial reports. Some years ago, a series of arti- cles in the financial press about Chrysler Corporation referred to the company’s breakeven point. At that time Chrysler’s breakeven point was 1.8 million vehicles a year. One article said that this breakeven point was reasonable because Chrysler had sold about 2.3 million vehicles in the previous year, but that the breakeven point was higher than Chrysler would like it to be heading into the trough of the industry’s sales cycle. Although now out-of-date, these articles illustrate the importance of breakeven. The breakeven point for the company example (i.e., the sales volume at which the company’s profit would be zero) is computed as follows: $6,534,250 annual fixed expenses ᎏᎏᎏᎏ = 421,242 units $15.51 unit contribution margin Technical note: Contribution margin per unit shown here is a rounded figure; the precise contribution margin per unit is used in calculating breakeven volume. If the business had sold only 421,242 units during the year it would have earned zero profit (earnings before income tax). The company’s taxable income would have been zero and its income tax would have been zero. So net income would have been zero. Figure 8.2 illustrates the breakeven sales volume scenario. The breakeven volume is a useful point of reference. It’s a118
  • 128. BREAKING EVEN AND MAKING PROFITSales Volume 421,242 Units Per Unit TotalsSales revenue $68.56 $28,879,837Cost-of-goods-sold expense ($43.15) ($18,175,484)Gross margin $25.41 $10,704,353Variable revenue-driven operating expenses ($ 5.27) ($ 2,220,175)Variable unit-driven operating expenses ($ 4.63) ($ 1,949,928)Contribution margin $15.51 $ 6,534,250Fixed operating expenses ($ 5,739,250)Operating profit $ 795,000Interest expense ($ 795,000)Earnings before income tax $ 0Income tax expense $ 0Net income $ 0Note: Pro forma means “as if,” or based on certain conditions or circumstances.FIGURE 8.2 Pro forma profit report at hypothetical breakeven volume.good way to express the total fixed-costs commitment of abusiness (i.e., how many units have to be sold just to coverfixed costs). Also, sales volume can be compared againstbreakeven volume to measure a company’s margin of safety.Furthermore, breakeven volume is very useful in analyzingprofit behavior at different levels of sales volume.Cash Flow BreakevenAs explained previously, depreciation is a fixed cost, but it isdifferent in one very important respect from other fixed costs.Depreciation is not a cash outlay in the year the expense isrecorded. The other fixed costs of a business are cash-based.Some of these fixed costs are prepaid (such as insurance pre-miums paid in advance for future coverage), and many arepaid after the expense is recorded in either the accountspayable or the accrued expenses payable liability account. Butthe cash flows for these fixed costs take place mostly in theperiod in which the expenses are recorded. In contrast, thereis no cash payment for depreciation expense. 119
  • 129. PROFIT AND CASH FLOW ANALYSIS Therefore, depreciation can be stripped out of the fixed costs for the period and the cash flow breakeven volume can be calculated as follows: $6,534,250 annual total fixed expenses − $768,450 depreciation expense for year $5,765,800 cash-based fixed expenses for year = ᎏᎏᎏᎏᎏ ᎏ $15.51 unit contribution margin = 371,703 units For cash flow analysis, this concept of breakeven is rele- vant. But managers are much more concerned about profit numbers that will be presented in the business’s external income statement and its internal profit reports. So, the most used concept of breakeven includes all fixed costs. Margin of Safety One purpose of calculating breakeven is to compare it against actual sales volume. The excess of actual sales volume over breakeven sales volume provides the measure of a company’s margin of safety. This excess over breakeven sales volume reveals how much the company’s sales would have to drop before the business slips out of the black and into the red— from profit to loss. The company sold 578,500 units during the year just ended compared with its 421,242 units breakeven volume. So it sold 157,258 units over its breakeven, which is its margin of safety. The company’s margin of safety equals 27 percent of its actual sales volume for the year (157,258 units excess over breakeven ÷ 578,500 units sold during the year = 27%). Of course this 27 percent margin of safety does not nec- essarily guarantee a profit next year. Sales could drop dramat- ically, or expenses could rise dramatically. Later chapters explore what would happen based on changes in the key fac- tors that drive profit. Pathway to Profit #2: Jumping the Breakeven Hurdle A second way to calculate profit is to use the number of units sold in excess over breakeven as the source of profit, as follows:120
  • 130. BREAKING EVEN AND MAKING PROFIT 578,500 total units sold (sales volume) − 421,242 breakeven volume = 157,258 units sold in excess of breakeven × $15.51 contribution margin per unit = $2,439,365 profitTechnical note: Contribution margin per unit shown here is arounded figure; the precise contribution margin per unit isused in calculating profit. This method assigns the first 421,242 units sold during theyear to covering fixed expenses. In other words, the contribu-tion margin from the first 421,242 units sold during the yearis viewed as consumed by fixed expenses. The 157,258 unitssold in excess of the breakeven volume are viewed as thesource of profit. In other words, annual sales volume isdivided into two piles: (1) the breakeven group and (2) theprofit group. Profit is the same amount as calculated by the first method,although the method of getting there is different. The differ-ence is a little more complex than meets the eye. It’s not justan exercise with numbers; it concerns how managers thinkabout making profit in the first place. The first method ofcomputing profit stresses the multiplication of unit contribu-tion margin by sales volume to get total contribution marginfor the period. Fixed expenses are not ignored, but arededucted from total contribution margin to work down toprofit. In contrast, the excess over breakeven method putsfixed expenses first and profit second—the business first hasto exceed its fixed expenses before it gets into the black.Pathway to Profit #3: Average Profit Per UnitThe excess over breakeven profit method divides sales volumeinto two piles: (1) the breakeven quantity necessary to covertotal fixed expenses and (2) the surplus over breakeven vol-ume that provides profit. A third pathway to profit dividesevery unit sold into two parts: fixed expenses and profit. The basic concept of the third method is that profit derivesfrom spreading fixed expenses over a sufficiently large sales 121
  • 131. PROFIT AND CASH FLOW ANALYSIS volume to ensure that the average fixed cost per unit is less than the contribution margin per unit. The fundamental think- ing is that every unit sold has to do two things: (1) contribute its share to cover fixed expenses and (2) provide a profit resid- ual. The computation of profit by this method is as follows: $6,534,250 total fixed costs ÷ 578,500 units sales volume for year = $11.29 average fixed cost per unit sold versus $15.51 contribution margin per unit = $ 4.22 average profit per unit × 578,500 total units sold (sales volume) = $2,439,365 profit Technical note: The contribution margin per unit, average fixed cost per unit, and average profit per unit are rounded figures; the precise figures for each are used in calculating profit. This method spreads fixed expenses for the year over the total number of units sold, which gives $11.29 as the average fixed cost per unit. Profit according to this method is viewed as the spread between the $11.29 average fixed cost per unit and the $15.51 contribution margin per unit, which is $4.22 average profit per unit. Of course, the amount of profit for the year (earnings before income tax) is the same as for the two computation methods explained previously. Suppose the business had sold only 421,242 units (its breakeven volume). The average fixed expenses per unit sold would have been much higher. In fact, it would have been $15.51 per unit ($6,534,250 total fixed expenses ÷ 421,242 units breakeven volume = $15.51 average fixed cost per unit). In this hypothetical situation the average fixed cost per unit would equal the average contribution margin per unit. So the business would have made precisely zero profit per unit. In other words, profit would be zero.s END POINT Because a business has fixed expenses, it has to worry about its breakeven point—which is determined by dividing its total122
  • 132. BREAKING EVEN AND MAKING PROFITfixed expenses for the period by its contribution profit marginper unit. The breakeven point is that precise sales volume atwhich the business’s sales revenue would equal its totalexpenses and thus would experience exactly zero profit. Theonly advantage of breaking even is that the business wouldhave no income tax to pay. At breakeven, the company’sbottom-line net income is zero. Of course, a business doesnot deliberately try to earn zero profit. This chapter examines the nature of fixed expenses, espe-cially the depreciation expense component of fixed expenses,noting that fixed expenses are not really 100 percent fixedand unchangeable, but are treated as if they were over theshort run for breakeven analysis and for examining the path-ways to profit. The chapter demonstrates the three differentways to compute profit, each of which has unique advantagesfor management analysis. The manager may find one moreuseful than the others in a given situation or for explainingthe profit strategy of his or her business to others. 123
  • 133. TE AM FL Y
  • 134. 9 CHAPTERSales Volume ChangesBBusiness managers face constant change in the pursuit ofprofit. All profit factors are subject to change—due to bothexternal changes beyond the control of the business andchanges initiated by the managers themselves. Many manage-ment decisions are triggered by change. Indeed, managers areoften characterized as change agents. Its suppliers may increase the purchase costs of the prod-ucts sold by the business. Or the cost of manufacturing prod-ucts may change, as may the productivity performance of itsmanufacturing operations. The company may raise wages forsome or all of its employees, or wage rates might actually bereduced by employee givebacks or downsizing. The landlordmay raise the rent; competitors may drop their sales pricesand the business may have to follow suit. Managers maydecide to raise sales prices. And so on. One basic function of managers is to keep a close watchon all relevant changes and know how to deal with thosechanges. Changes set in motion a new round of profit-makingdecisions. This chapter is the first of four that analyze theimpact of changes in the factors that drive profit. The basicfactors are changed to determine the resulting change inprofit. For example, if you sold 10 percent more units, wouldyour profit be 10 percent higher? Nope, it’s not as simple asthis, and managers should know why. 125
  • 135. PROFIT AND CASH FLOW ANALYSIS THREE WAYS OF MAKING A $1 MILLION PROFIT By and large, previous chapters take a macro, or business-as- a-whole, approach to profit analysis techniques that business managers need to understand. This chapter shifts gears and takes more of a micro and focused point of view. The typical business consists of many different profit pieces, or profit modules, as I prefer to call them. A profit module is a separate identifiable source of sales and profit of a business. A product line is a typical example of a profit module. One product by itself could be a profit module if the product stands alone and generates a significant amount of sales rev- enue and profit. A separate store location or each branch of a business could be operated as a separate segment of the busi- ness and, accordingly, be accounted for as a profit module. Organizational units that have profit responsibility are also called profit centers. A profit center may consist of two or more profit modules. A brand generally covers too broad a range of different prod- ucts to be just one profit module, although in some cases a brand might be a profit module. Managers have to figure out the best way to organize their sales activities into separate and distinguishable profit modules, which are the constituent profit members of the whole business. For each one of these organizational slices of the total business, a meaningful mea- sure of profit is adopted that is appropriate for that particular management unit of the organization. Certain designated managers plan and control each profit module, which is nec- essary to achieve the overall profit goals of the business. Figure 9.1 presents management profit reports for three contrasting profit modules of a business. Each is a basic prod- uct line of the business. The generic product line is an exam- ple of high volume and low unit margin. The business’s premier product line is at the opposite end of the how-to- make-profit spectrum—low volume and high unit margin. Its standard product line falls in the middle—moderate volume and moderate unit margin. Each product line generated a $1 million profit for the year just ended. I designed these three examples so that profit is $1 million for each module. This makes it easier to compare the impacts caused by changes in profit factors between the three product126
  • 136. SALES VOLUME CHANGESStandard Product Line 100,000 units sold Per Unit TotalsSales revenue $100.00 $10,000,000Cost of goods sold $ 65.00 $ 6,500,000Gross margin $ 35.00 $ 3,500,000Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000Unit-driven expenses $ 6.50 $ 650,000Contribution margin $ 20.00 $ 2,000,000Fixed operating expenses $ 10.00 $ 1,000,000Profit $ 10.00 $ 1,000,000Generic Product Line 150,000 units sold Per Unit TotalsSales revenue $ 75.00 $11,250,000Cost of goods sold $ 57.00 $ 8,550,000Gross margin $ 18.00 $ 2,700,000Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000Unit-driven expenses $ 5.00 $ 750,000Contribution margin $ 10.00 $ 1,500,000Fixed operating expenses $ 3.33 $ 500,000Profit $ 6.67 $ 1,000,000Premier Product Line 50,000 units sold Per Unit TotalsSales revenue $150.00 $ 7,500,000Cost of goods sold $ 80.00 $ 4,000,000Gross margin $ 70.00 $ 3,500,000Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500Unit-driven expenses $ 8.75 $ 437,500Contribution margin $ 50.00 $ 2,500,000Fixed operating expenses $ 30.00 $ 1,500,000Profit $ 20.00 $ 1,000,000FIGURE 9.1 Three contrasting profit modules of a business. 127
  • 137. PROFIT AND CASH FLOW ANALYSIS lines. Profit is the same for all three modules, but the sales prices, unit margins, and fixed operating expenses are quite different for the three product lines. Note that the business had to sell three times as many units of its generic products (150,000 units) as its premier products (50,000 units) to earn the same profit. Chapter 8 explains the different ways of analyzing profit, which I call pathways to profit. The three management profit reports presented in Figure 9.1 for the three profit modules follow the layout of the #1 pathway to profit, as follows: Unit margin × sales volume = contribution margin − fixed costs = profit The management profit reports in Figure 9.1 also include data for the #3 pathway to profit. For instance, for the pre- miere product line the business spread its $1.5 million fixed costs over 50,000 units, which gives a $30.00 average fixed cost per unit sold. On this product line, the business makes a $50.00 unit margin, so its profit is $20.00 per unit, which multiplied times the 50,000 units sales volume gives $1 mil- lion profit for the year. The #2 pathway to profit is brought into play later to explain why the percent change in profit is greater than the percent change in sales volume. The three variable expenses per unit reported in Figure 9.1 for each profit module (i.e., product cost, revenue-driven, and unit-driven) are incremental costs. That is to say, if the business sells one more unit, then total cost increases by the per unit amounts shown in Figure 9.1. The total amount of each of these expenses for the period depends on the number of units sold (or sales volume). In contrast, the per- unit amount of fixed operating expenses for each product line is determined by dividing the total fixed costs for the period by the number of units sold. If the business had sold one unit more or one unit less than it did, the total amount of fixed costs for the period would be the same, but the128
  • 138. SALES VOLUME CHANGESaverage fixed cost per unit would be slightly differentbecause this is a calculated amount that depends on thenumber of units sold.Defining Profit and the Matter of Fixed CostsEach profit module (product line) shown in Figure 9.1 ischarged with its direct fixed operating expenses for the year.These include such costs as the salaries of the managers andother employees who work exclusively in this area of the busi-ness, advertising expenditures for the products (except for thegeneric product, which is not advertised), depreciation of vari-ous fixed assets used by each of these profit segments of thebusiness, and so on. Several fixed costs of the business cannotbe allocated directly to any of its profit modules (the generallegal costs of the business, the compensation of companywidetop-level executives, the cost of its annual independent audit,charitable contributions made by the business, the cost ofinstitutional advertising in which the name of the companybut no specific products are promoted, etc.). Every profit mod-ule is expected to earn a sufficient profit after deducting itsdirect fixed costs from its contribution margin. Summing up, each of the three profit modules in the exam-ple (see Figure 9.1) earned $1 million for the year just ended.These are profit amounts prior to taking into account the indi-rect fixed expenses of the business and the interest expenseand income tax expense of the business. The general managerof each product line is held accountable for its profit perform-ance, of course.SELLING MORE UNITSBusiness managers, quite naturally, are sales oriented. Nosales, no business; it’s as simple as that. As they say inmarketing—nothing happens until you sell it. Many busi-nesses do not make it through their start-up phase becauseit’s very difficult to build up and establish a sales base. Cus-tomers have to be won over. Once established, sales volumecan never be taken for granted. Sales are vulnerable to compe-tition, shifts in consumer preferences and spending decisions, 129
  • 139. PROFIT AND CASH FLOW ANALYSIS and general economic conditions both domestically and globally. Thinking more positively, sales volume growth is the most realistic way to increase profit. In most cases, sales price increases are met with some degree of customer resistance as well as a response from competitors. Indeed, demand may be extremely sensitive to sales prices. Cost containment and expense control are important, to be sure, but are more of a defensive tactic than a profit growth strategy as such. Suppose that for all three product lines the business sold 10 percent more units during the year just ended. What amount of profit would have been earned from each product line? Of course, there’s no such thing as a free lunch. An experienced manager would ask how the business could increase its sales volume. Would customers buy 10 percent more without any increase in advertising, without any sales price incentives, without some product improvements or other inducements? Not too likely. Increasing sales volume usually requires some stimulant such as more advertising. Another question an experienced manager might ask is whether the business has enough capacity to handle 10 per- cent additional sales. It’s always a good idea to run a capacity check whenever looking at sales volume increases. Fixed expenses may have to be increased to enlarge the capacity needed to accommodate the additional sales volume. How- ever, assume that the manager of each profit module had enough untapped capacity to take on 10 percent additional sales volume without having to increase any of his or her fixed operating expenses. Figure 9.2 presents the profit results for the 10 percent higher sales scenario for each product line. Sales prices, unit product costs, and variable expenses per unit remain the same in each of the three profit modules. And, the direct fixed costs of each product line remain the same. Therefore, at the higher sales volume the average fixed cost per unit is lower. For instance, consider the standard product line. At the origi- nal 100,000 units sales volume, the $1 million in fixed costs average out to $10.00 per unit. At the higher 110,000 units sales volume, the average fixed costs per unit drop $.91 per unit, so the business makes $10.91 profit per unit. The driv- ing force behind the $200,000 increase in profit is selling130
  • 140. SALES VOLUME CHANGESStandard Product Line Original Scenarios (see Figure 9.1) Changes 100,000 units sold 10,000 additional units Per Unit Totals Per Unit TotalsSales revenue $100.00 $10,000,000 $1,000,000Cost of goods sold $ 65.00 $ 6,500,000 $ 650,000Gross margin $ 35.00 $ 3,500,000 $ 350,000Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 $ 85,000Unit-driven expenses $ 6.50 $ 650,000 $ 65,000Contribution margin $ 20.00 $ 2,000,000 $ 200,000 10%Fixed operating expenses $ 10.00 $ 1,000,000 ($0.91) $ 0Profit $ 10.00 $ 1,000,000 $0.91 $ 200,000 20%Generic Product Line 150,000 units sold 15,000 additional units Per Unit Totals Per Unit TotalsSales revenue $ 75.00 $11,250,000 $1,125,000Cost of goods sold $ 57.00 $ 8,550,000 $ 855,000Gross margin $ 18.00 $ 2,700,000 $ 270,000Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 $ 45,000Unit-driven expenses $ 5.00 $ 750,000 $ 75,000Contribution margin $ 10.00 $ 1,500,000 $ 150,000 10%Fixed operating expenses $ 3.33 $ 500,000 ($0.30) $ 0Profit $ 6.67 $ 1,000,000 $0.30 $ 150,000 15%Premier Product Line 50,000 units sold 5,000 additional units Per Unit Totals Per Unit TotalsSales revenue $150.00 $ 7,500,000 $ 750,000Cost of goods sold $ 80.00 $ 4,000,000 $ 400,000Gross margin $ 70.00 $ 3,500,000 $ 350,000Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 $ 56,250Unit-driven expenses $ 8.75 $ 437,500 $ 43,750Contribution margin $ 50.00 $ 2,500,000 $ 250,000 10%Fixed operating expenses $ 30.00 $ 1,500,000 ($2.73) $ 0Profit $ 20.00 $ 1,000,000 $2.73 $ 250,000 25%FIGURE 9.2 10 percent higher sales volumes. 131
  • 141. PROFIT AND CASH FLOW ANALYSIS 10,000 additional units at a $20.00 unit margin, not the decrease in average fixed cost per unit. This decrease is sim- ply one result of the higher sales volume. In all three cases, contribution margin improves exactly 10 percent, the same as the percent of sales volume increase. This is straightforward: Selling 10 percent more units with no change in unit margin drives up contribution margin exactly 10 percent. But please note the difference in the amounts of the contribution margin increases: Contribution Margin Increases for Each Product Line Premier 5,000 units increase × $50.00 unit margin = $250,000 Standard 10,000 units increase × $20.00 unit margin = $200,000 Generic 15,000 units increase × $10.00 unit margin = $150,000 Selling 10 percent more premier units would bring in a $50,000 higher contribution margin than would selling 10 percent more standard units. And selling 10 percent more standard units would make $50,000 more profit than selling 10 percent generic units. Operating Leverage Note in Figure 9.2 that even though contribution margin increases 10 percent for each product line because of the 10 percent higher sales volume levels, the per- cent increases in profit are 1.5 to 2.5 times greater. For instance, profit on the standard product line would be 20 per- cent higher, or two times the 10 percent sales volume increase. The $200,000 increase in contribution margin equals 10 per- cent gain, but the $200,000 gain is 20 percent on the profit fig- ure. In short, the 10 percent sales volume increase has a doubling effect on the percent increase in profit. The multi- plier, or compounding effect is called operating leverage. The additional 10,000 units sold equal 10 percent of the total units sold, but they equal 20 percent of the units sold in excess of the product line’s breakeven point. The profit pile, or units sold in excess of breakeven, expands by 20 percent. This132
  • 142. SALES VOLUME CHANGESanalysis is summarized as follows for the standard productline (data from Figure 9.2):Analysis of Operating Leverage Effect$1,000,000 fixed costs ÷ $20.00 unit margin = 50,000 units breakeven100,000 units sales volume − 50,000 units breakeven = 50,000 units over breakeven10,000 additional units sold ÷ 50,000 units over breakeven = 20% increase So profit would increase 20 percent by increasing sales vol-ume just 10 percent, as shown in Figure 9.2. In like manner,the percent of gain in profit (15 percent for generic productsand 25 percent for premier products) can be calculated. The nub of operating leverage is that the swing in profit ismore than the sales volume swing. Operating leverage meansthat profit percent changes are a multiple of sales volume per-cent changes. There’s hardly ever a 1:1 percent relationship.This rule is based on fixed expenses remaining constant at thehigher sales level. If fixed expenses increase 10 percent rightalong with the sales volume increase (i.e., if fixed operatingexpenses increase 10 percent as well), then profit would go uponly 10 percent.Operating leverage reflects the fact that the business has notbeen fully using the capacity provided by its fixed costs. Whencapacity is reached, and sooner or later it will be as sales vol-ume grows, fixed expenses will have to be increased to pro-vide more capacity. If the company had already been selling atits maximum capacity, then its fixed expenses would have hadto be increased. This points out the importance of knowingwhere you are presently relative to the company’s capacity.SALES VOLUME SLIPPAGESuppose that the sales volumes had been 10 percent lowerduring the year just ended across the board for all three prod-uct lines. The effects of this downside scenario are presentedin Figure 9.3, which is basically the negative mirror image ofthe 10 percent sales volume increase scenario. It’s a good ideafor the managers of each product line to keep this lower sales 133
  • 143. PROFIT AND CASH FLOW ANALYSIS volume, or worst-case scenario, in mind so they know just how sensitive profit is to a falloff in sales volume. The combined impact for all three product lines would have been a profit drop-off of $600,000, from $3 million in the original scenario to only $2.4 million profit in the 10 percent lower sales volume. When faced with a falloff in sales volume, managers should be very concerned, of course, and they should probe into the reasons for the decrease. More competition? Are people switching to substitute products? Are hard times forcing cus- tomers to spend less? Is the location deteriorating? Has ser- vice to customers slipped? Are total quality management (TQM) techniques needed to correct the loss of sales? Sales volume losses are one of the most serious problems confronting any business. Unless they are quickly reversed, the business has to make extremely wrenching decisions regarding how to downsize (laying off employees, selling off Y fixed assets, shutting down plants, etc.). The late economist FL Kenneth Boulding has called downsizing the management of decline, which hits the nail on the head, I think. It’s an extremely unpleasant task, to say the very least. AM The immediate (short-run) operating profit impact of a 10 percent sales volume decrease would depend heavily on whether the company could reduce its fixed expenses at the TE lower sales level. Assume not. In Figure 9.3, fixed operating expenses remain the same at the lower sales levels for each product line. In the sales decline scenario, operating leverage compounds the felony—profit decreases by a multiple of the 10 percent sales volume decrease in this scenario. FIXED COSTS AND SALES VOLUME CHANGES In analyzing the profit impacts of changes in sales volume, there is the question regarding what to do with fixed operat- ing expenses. The simple expedient is to keep fixed costs the same at the higher or the lower sales volume. However, this is not an entirely satisfactory solution. For very small changes in sales volume, fixed costs do not change. In other words, fixed costs are insensitive to relatively small changes in sales volume. In the typical situation, most fixed costs (e.g., depreciation expense recorded in the period, labor cost for employees paid monthly fixed salaries, and amounts paid for insurance pre-134
  • 144. SALES VOLUME CHANGESStandard Product Line Original Scenarios (see Figure 9.1) Changes 100,000 units sold 10,000 additional units Per Unit Totals Per Unit TotalsSales revenue $100.00 $10,000,000 ($1,000,000)Cost of goods sold $ 65.00 $ 6,500,000 ($ 650,000)Gross margin $ 35.00 $ 3,500,000 ($ 350,000)Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 ($ 85,000)Unit-driven expenses $ 6.50 $ 650,000 ($ 65,000)Contribution margin $ 20.00 $ 2,000,000 ($ 200,000) −10%Fixed operating expenses $ 10.00 $ 1,000,000 $1.11 $ 0Profit $ 10.00 $ 1,000,000 ($1.11) ($ 200,000) −20%Generic Product Line 150,000 units sold 15,000 additional units Per Unit Totals Per Unit TotalsSales revenue $ 75.00 $11,250,000 ($1,125,000)Cost of goods sold $ 57.00 $ 8,550,000 ($ 855,000)Gross margin $ 18.00 $ 2,700,000 ($ 270,000)Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 ($ 45,000)Unit-driven expenses $ 5.00 $ 750,000 ($ 75,000)Contribution margin $ 10.00 $ 1,500,000 ($ 150,000) −10%Fixed operating expenses $ 3.33 $ 500,000 $0.37 $ 0Profit $ 6.67 $ 1,000,000 ($0.37) ($ 150,000) −15%Premier Product Line 50,000 units sold 5,000 additional units Per Unit Totals Per Unit TotalsSales revenue $150.00 $ 7,500,000 ($ 750,000)Cost of goods sold $ 80.00 $ 4,000,000 ($ 400,000)Gross margin $ 70.00 $ 3,500,000 ($ 350,000)Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 ($ 56,250)Unit-driven expenses $ 8.75 $ 437,500 ($ 43,750)Contribution margin $ 50.00 $ 2,500,000 ($ 250,000) −10%Fixed operating expenses $ 30.00 $ 1,500,000 $3.33 $ 0Profit $ 20.00 $ 1,000,000 ($3.33) ($ 250,000) −25%FIGURE 9.3 10 percent lower sales volumes. 135
  • 145. PROFIT AND CASH FLOW ANALYSIS miums) would not be any different if sales volume had been 1 or 2 percent higher or lower, or even 5, 10, or 20 percent dif- ferent in either direction. But at some point a business will have to increase its fixed costs to provide additional capacity on the upside or will have to cut fixed costs on the downside. In the preceding analysis, the assumption is made that each product line has enough capacity to take on 10 percent addi- tional sales volume without any increase in the direct fixed costs of the profit module. Keep in mind, however, that one or more fixed operating expenses might have to increase to sup- port a higher sales volume. For instance, the business might have to rent more retail floor space, hire more salaried employees, or purchase additional equipment on which depreciation is recorded. For a moderate increase in sales vol- ume, fixed expenses generally hold steady and don’t increase, as a general rule, unless the business already is running at virtually 100 percent of its capacity. Faced with moderate decreases in sales volume, businesses generally hold off and delay any serious reduction in capacity that would require laying off employees. Employees usually have been trained and have valuable experience to offer a business. It may be difficult to reduce many fixed expenses, at least in the short run. Some fixed expenses can be adjusted downward in short order. But if you had time to look at the typical fixed costs of a business, I think you would find that unwinding from many of the expenses would take time and would have serious consequences to the business. Finally, I would mention that in dire circumstances, such as when a business goes into bankruptcy, all bets are off. A busi- ness may have to slash many fixed costs under pressures from creditors or by court order. Also, in takeover situations, in which one business buys out another business, often a key element of the takeover strategy is to drastically reduce the fixed costs of the acquired business. This often means laying off hundreds of thousands of employees and selling off assets.s END POINT All profit factors are subject to change. Management neglect or ineptitude can lead to profit deterioration, sometimes very quickly. Increases in product cost as well as increases in vari-136
  • 146. SALES VOLUME CHANGESable and fixed expenses can do serious damage to profit per-formance. But managers may not be able to significantlyimprove certain factors. Fixed expenses may already be cut tothe bone. One vendor may control product costs, or alterna-tive vendors may offer virtually the same prices. Competitionmay put a fairly tight straitjacket on sales prices. Customersare sensitive to sales price increases. Sales volume is the keysuccess factor for most businesses, which explains why man-agers are so concerned about market share. Market share ismentioned often in later chapters. 137
  • 147. 10 CHAPTERSales Price andCost ChangesBBefore we go any further, let me ask you a basic question.Suppose you could have one or the other, but not both, whichwould you prefer—a 10 percent sales volume increase or a 10percent sales price increase? In most cases, there’s a huge dif-ference between the two. This chapter contrasts the differencebetween sales volume and sales price changes. You may besurprised. In any case, you should be very certain about thedifferences!SALES PRICE CHANGESSetting sales prices is one of the most perplexing decisionsfacing business managers. Competition normally dictates thebasic range of sales prices. But usually there is some room fordeviation from your competitors’ prices because of productdifferentiation, brand loyalty, location advantages, and/orquality of service, to cite only a few of the many reasons thatpermit you to charge higher sales prices than your competi-tion.Fixed operating expenses are insensitive to sales priceincreases. In contrast, sales volume increases may very wellrequire increases in fixed operating expenses, especially whenthe company’s capacity is crowded. Very few fixed expensesare directly affected by raising sales prices, even if the company 139
  • 148. PROFIT AND CASH FLOW ANALYSIS is operating at full capacity. Advertising (a fixed cost once spent) might be stepped up to persuade customers that the hike in sales prices is necessary or beneficial. Other than this, it’s hard to find many fixed operating expenses that are tied directly to sales price increases. The same three profit module examples used in Chapter 9 for analyzing sales volume changes are used in this chapter to analyze sales price changes. This allows the comparison of the differences between the profit impacts of selling more or fewer units versus selling the same number of units but at higher or lower sales prices. With this in mind, consider the hypothetical scenario in which the business could have sold the same number units of each product line at 10 percent higher sales prices. Figure 10.1 presents this scenario for the three profit modules examples. Profit more than doubles on the generic product line; and profit increases 92 percent and 69 percent on the standard and premier product lines, respectively (see Figure 10.1). Would this be realistic? Only to the extent that a 10 percent sales price increase would be realistic. Assume that the busi- ness could have sold all units during the year at the higher sales prices. The advantages of selling at 10 percent higher sales prices compared with selling 10 percent more sales vol- ume are summarized in Figure 10.2. In this scenario only one variable operating expense would increase—the one driven by sales revenue. Note that cost-of- goods-sold expense does not increase because the volume sold remains the same. In the sales volume increase situation (Chapter 9), the sales revenue increase is offset substantially by the increase in cost-of-goods-sold expense. In contrast, consider the standard product line here in the sales price increase case: $915,000 of the $1 million incremental sales revenue flows through to profit. Chapter 3 introduces the format and logic of an internal management profit report. One key point is that expenses should be classified and reported according to their behavior, or what drives them.* Some operating expenses depend *Cost driver is a popular term these days. This refers to the specific factors that determine, or push, or drive a particular cost. Identifying cost drivers is the key step in the method of cost analysis and allocation called activity- based costing (ABC). Cost allocation is discussed in Chapter 18.140
  • 149. SALES PRICE AND COST CHANGESStandard Product Line Original Scenarios (see Figure 9.1) Changes 100,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $100.00 $10,000,000 $10.00 $1,000,000 10%Cost of goods sold $ 65.00 $ 6,500,000Gross margin $ 35.00 $ 3,500,000Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 $ 0.85 $ 85,000Unit-driven expenses $ 6.50 $ 650,000Contribution margin $ 20.00 $ 2,000,000 $ 9.15 $ 915,000 46%Fixed operating expenses $ 10.00 $ 1,000,000Profit $ 10.00 $ 1,000,000 $ 9.15 $ 915,000 92%Generic Product Line 150,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $ 75.00 $11,250,000 $ 7.50 $1,125,000 10%Cost of goods sold $ 57.00 $ 8,550,000Gross margin $ 18.00 $ 2,700,000Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 $ 0.30 $ 45,000Unit-driven expenses $ 5.00 $ 750,000Contribution margin $ 10.00 $ 1,500,000 $ 7.20 $1,080,000 72%Fixed operating expenses $ 3.33 $ 500,000Profit $ 6.67 $ 1,000,000 $ 7.20 $1,080,000 108%Premier Product Line 50,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $150.00 $ 7,500,000 $15.00 $ 750,000 10%Cost of goods sold $ 80.00 $ 4,000,000Gross margin $ 70.00 $ 3,500,000Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 $ 1.12 $ 56,250Unit-driven expenses $ 8.75 $ 437,500Contribution margin $ 50.00 $ 2,500,000 $13.88 $ 693,750 28%Fixed operating expenses $ 30.00 $ 1,500,000Profit $ 20.00 $ 1,000,000 $13.88 $ 693,750 69%FIGURE 10.1 10 percent higher sales prices. 141
  • 150. PROFIT AND CASH FLOW ANALYSIS 10 Percent Sales 10 Percent Sales Volume Increase Price Increase (see Figure 9.2) (see Figure 10.1) Standard Product Line Contribution margin $200,000 10% $ 915,000 46% Profit $200,000 20% $ 915,000 92% Generic Product Line Contribution margin $150,000 10% $1,080,000 72% Profit $150,000 15% $1,080,000 108% Premier Product Line Contribution margin $250,000 10% $ 693,750 28% Profit $250,000 25% $ 693,750 69% FIGURE 10.2 Comparison of 10 percent higher sales prices versus 10 per- cent higher sales volumes. directly on the dollar amounts of sales, not the quantity of products sold. As total sales revenue (dollars) increases, these expenses increase directly in proportion. In short, one more dollar of sales revenue causes these expenses to increase by a certain amount of cents on the dollar. Most retailers accept national credit cards (Visa, Master- Card, Discover, American Express, Diners Club, etc.). The credit card charge slips are deposited daily with a local partic- ipating bank. The bank then discounts the total amount and credits the net balance in the business’s checking account. Discount rates vary between 2 and 4 percent (sometimes lower or higher). In short, a business nets only $.98 or $.96 from each dollar of credit card sales. The credit card discount expense comes right off the top of the sales dollar. Sales commissions are another common example of sales revenue-dependent expenses. As you probably know, many retailers and other businesses pay their sales representatives on a commission basis, usually a certain percent of the total sales amount such as 5 or 10 percent. The salespersons may also receive a base salary, which would be the fixed floor of the142
  • 151. SALES PRICE AND COST CHANGESexpense; only the commission over and above the fixed basewould be variable. (This requires the separation of the fixedpart and the variable part in the management profit report.) Many businesses extend short-term credit to their cus-tomers, especially when selling to other businesses. No matterhow carefully a business screens them before extending credit,a few customers never pay their accounts. Eventually, aftermaking repeated collection efforts, the business ends up havingto write off all or some of these receivables’ balances as uncol-lectible. These losses are called bad debts and are a normalexpense of doing business on credit. This expense depends onthe sales amount, not sales volume (number of units sold). Another example of an expense that varies with sales rev-enue is one you might not suspect—rent. Companies oftensign lease agreements that call for rental amounts based ongross sales. There may be a base amount or fixed minimummonthly rent. In addition, there may be a variable amountequal to a percent of total sales revenue. This is common forretailers renting space in shopping centers. There are severalother examples of expenses that vary with total sales revenue,such as franchise fees based on gross sales. Summing up, sales revenue increases 10 percent for thethree product lines (see Figure 10.1), but the incremental rev-enue is partially offset by the increase in the sales revenue-driven expenses. Thus the increases in contribution marginsare less than the increases in sales revenue. In Figure 10.1 it isassumed that the fixed operating expenses of the profit mod-ules do not change at the higher sales price levels. Thus, thecontribution margin increases flow down to the profit lines.Increasing sales volume 10 percent increases total contribu-tion margin only 10 percent because the contribution marginper unit remains the same. And fixed operating expenses mayhave to be increased to support the higher sales volume. (Inthe examples, these fixed costs are held constant at the highersales volume.) Increasing sales prices 10 percent improvescontribution margin per unit much more than 10 percent, andtotal contribution margin rises accordingly. Note the standardproduct line, for instance (Figure 10.1). The contribution mar-gin per unit increases $9.15, which is a 46 percent jump overthe $20.00 figure before the sales price increase. Thus, totalcontribution margin increases $915,000, or 46 percent, at the 143
  • 152. PROFIT AND CASH FLOW ANALYSIS higher sales price. And fixed operating expenses should not be affected by the higher sales price. Frankly, a 10 percent increase in sales price with no increase in the product cost and no increase in the other expenses of the company is not too likely to happen. It is pre- sented here to illustrate the powerful impact of a sales price increase and to contrast it with a 10 percent increase in sales volume (see Figure 10.2 again). Also, I should mention here that the cash flow impact of a 10 percent sales price increase differs from that of a sales volume increase like day from night (see Chapter 13). WHEN SALES PRICES HEAD SOUTH Like it or not, business managers sometimes have to cutDANGER! sales prices just to hang onto the present sales volume they have. They know that profit will suffer, but competitive pres- Y sures force them to cut sales prices, at least temporarily. Or FL they decide to cut prices to boost sales volume, but the number of units sold in fact remains the same, and later they have to nudge sales prices back up to previous levels. A 10 percent AM sales price cut would be the negative mirror image of the effects caused by the 10 percent sales price increase. Just put negative signs in front of the changes you see in Figure 10.1. If TE this happened, all the profit and then some would be wiped out on the generic product line, over 90 percent of the profit on the standard product line would evaporate, and the business would give up over 69 percent of its profit from the premier products. To illustrate the serious profit damage from even a rela- tively small decrease in the average sales price of products over a period of time, assume that during the year just ended the business had to cut sales prices at times during the year such that, on average, the sales prices of the products sold in the three product lines suffered by 4 percent. This may not sound like too much of a catastrophe, but look at the results shown in Figure 10.3 for this scenario. Sales prices and sales revenue drop by 4 percent, but profit plunges from 28 to 43 percent, depending on the product line. The reason for the lower drop in profit for the premier product line is that the unit margin of these products is a much larger percent of sales price, so a 4 percent cut in sales price doesn’t take such a big bite out of the unit margin. For144
  • 153. SALES PRICE AND COST CHANGESStandard Product LineOriginal Scenarios (see Figure 9.1) Changes 100,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $100.00 $10,000,000 ($4.00) ($400,000) −4%Cost of goods sold $ 65.00 $ 6,500,000Gross margin $ 35.00 $ 3,500,000Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 ($0.34) ($ 34,000)Unit-driven expenses $ 6.50 $ 650,000Contribution margin $ 20.00 $ 2,000,000 ($3.66) ($366,000) −18%Fixed operating expenses $ 10.00 $ 1,000,000Profit $ 10.00 $ 1,000,000 ($3.66) ($366,000) −37%Generic Product Line 150,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $ 75.00 $11,250,000 ($3.00) ($450,000) −4%Cost of goods sold $ 57.00 $ 8,550,000Gross margin $ 18.00 $ 2,700,000Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 ($0.12) ($ 18,000)Unit-driven expenses $ 5.00 $ 750,000Contribution margin $ 10.00 $ 1,500,000 ($2.88) ($432,000) −29%Fixed operating expenses $ 3.33 $ 500,000Profit $ 6.67 $ 1,000,000 ($2.88) ($432,000) −43%Premier Product Line 50,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $150.00 $ 7,500,000 ($6.00) ($300,000) −4%Cost of goods sold $ 80.00 $ 4,000,000Gross margin $ 70.00 $ 3,500,000Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 ($0.45) ($ 22,500)Unit-driven expenses $ 8.75 $ 437,500Contribution margin $ 50.00 $ 2,500,000 ($5.55) ($277,500) −11%Fixed operating expenses $ 30.00 $ 1,500,000Profit $ 20.00 $ 1,000,000 ($5.55) ($277,500) −28%FIGURE 10.3 4 percent lower sales prices. 145
  • 154. PROFIT AND CASH FLOW ANALYSIS comparison, the 4 percent (or $3.00) sales price cut for the generic products, net of the decrease in the revenue-driven expenses, represents a 29 percent reduction in the unit mar- gin on these products. For the premier products, the 4 percent (or $6.00) price cut (net of the decrease in its revenue-driven expenses) is only an 11 percent reduction in the unit margin. CHANGES IN PRODUCT COST AND OPERATING EXPENSES In most cases, changes in sales volume and sales prices have the biggest impact on profit performance. Product cost proba- bly would rank as the next most critical factor for most busi- nesses (except for service businesses that do not sell products). A retailer needs smart, tough-nosed, sharp-pencil, aggressive purchasing tactics to control its product costs. On the other hand, it can be carried to an extreme. I knew a purchasing agent (a neighbor when I lived in Cali- fornia some years ago) who was a real tiger. For instance, George would even return new calendars sent by vendors at the end of the year with a note saying, “Don’t send me this calendar; give me a lower price.” This may be overkill, though George eventually became general manager of the business. Even with close monitoring and relentless control, both theDANGER! variable and fixed operating expenses of a business may increase. Salaries, rent, insurance, utility bills, and audit and legal fees—virtually all operating expenses—are subject to inflation. To illustrate this situation, consider the scenario in which sales prices and sales volume remain the same but the company’s product costs and its variable and fixed operating expenses increase. In particular, assume that the business’s product costs and its unit-driven variable expenses increase 10 percent. Fixed costs increase only, say, 8 percent, because the depreciation expense component of total fixed expenses remains unchanged. Depreciation is based on the original cost of fixed assets and is not subject to the general inflationary pressures on operating expenses. Revenue-driven variable expenses, being a certain percent of sales revenue, do not change, because in this scenario sales revenue does not change (sales volumes and sales prices for each product line don’t change). Figure 10.4 presents the effects for this cost inflation146
  • 155. SALES PRICE AND COST CHANGESStandard Product Line Original Scenarios (see Figure 9.1) Changes 100,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $100.00 $10,000,000Cost of goods sold $ 65.00 $ 6,500,000 $6.50 $650,000 10%Gross margin $ 35.00 $ 3,500,000Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000Unit-driven expenses $ 6.50 $ 650,000 $0.65 $ 65,000 10%Contribution margin $ 20.00 $ 2,000,000 ($7.15) ($715,000) −36%Fixed operating expenses $ 10.00 $ 1,000,000 $0.80 $ 80,000 8%Profit $ 10.00 $ 1,000,000 ($7.95) ($795,000) −80%Generic Product Line 150,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $ 75.00 $11,250,000Cost of goods sold $ 57.00 $ 8,550,000 $5.70 $855,000 10%Gross margin $ 18.00 $ 2,700,000Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000Unit-driven expenses $ 5.00 $ 750,000 $0.50 $ 75,000 10%Contribution margin $ 10.00 $ 1,500,000 ($6.20) ($930,000) −62%Fixed operating expenses $ 3.33 $ 500,000 $0.27 $ 40,000 8%Profit $ 6.67 $ 1,000,000 ($6.47) ($970,000) −97%Premier Product Line 50,000 units sold No change Per Unit Totals Per Unit TotalsSales revenue $150.00 $ 7,500,000Cost of goods sold $ 80.00 $ 4,000,000 $8.00 $400,000 10%Gross margin $ 70.00 $ 3,500,000Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500Unit-driven expenses $ 8.75 $ 437,500 $0.88 $ 43,750 10%Contribution margin $ 50.00 $ 2,500,000 ($8.88) ($443,750) −18%Fixed operating expenses $ 30.00 $ 1,500,000 $2.40 $120,000 8%Profit $ 20.00 $ 1,000,000 ($11.28) ($563,750) −56%FIGURE 10.4 Higher costs. 147
  • 156. PROFIT AND CASH FLOW ANALYSIS scenario. As you can see, it’s not a pretty picture. The com- pany could ill afford to let its product costs and operating expenses get out of control. Virtually all (97 percent) of the profit on the generic product line would be eliminated in this case. The profit on the standard product line would plunge 80 percent, and the profit on the premier product line would suf- fer 56 percent. If the cost increases could not be avoided, then managers would have the unpleasant task of passing the cost increases along to their customers in the form of higher sales prices.s END POINT If you had your choice, the best change is a sales price in- crease, assuming all other profit factors remain the same. A sales price increase yields a much better profit result than a sales volume increase of equal magnitude. Increasing sales volume ranks a distant second behind raising sales prices. Of course, customers are sensitive to sales price increases, and as a practical matter the only course of action to increase profit may be to sell more units at the established sales prices. Sales volume and sales prices are the two big factors driving profit. However, cost factors cannot be ignored, of course. The unit costs of the products sold by the business and vir- tually all its operating costs—both variable and fixed—can change for the worse. Such unfavorable cost shifts would cause devastating profit impacts unless they are counterbal- anced with prompt increases in sales prices. This and other topics are explored in the following chapters.148
  • 157. 11 CHAPTERPrice/VolumeTrade-OffsRRaising sales prices may very well cause sales volume to fall.Cutting sales prices may increase sales volume—unless com-petitors lower their prices also. Higher sales prices may be inresponse to higher product costs that are passed through tocustomers. Increasing product costs to improve product qual-ity may jack up sales volume. Increasing sales commissions (aprime revenue-driven expense) may give the sales staff justthe incentive needed to sell more units. Spending more onfixed operating expenses—such as bigger advertising budgets,higher rent for larger stores, or more expensive furnishings—may help sales volume. None of this is news to experienced business managers.The business world is one of trade-offs among profit factors.In most cases, a change in one profit factor causes, or is inresponse to, a change in another factor. Chapters 9 and 10 analyze profit factor changes one at atime; the other profit factors are held constant. (To be techni-cally correct here, I should note that sales price changes causerevenue-driven expenses to change in proportion.) In the realworld of business, seldom can you change just one thing at atime. This chapter analyzes the interaction of changes in twoor more profit factors. 149
  • 158. PROFIT AND CASH FLOW ANALYSIS SHAVING SALES PRICES TO BOOST SALES VOLUME The example of the three profit modules introduced in Chapter 9 and carried through in Chapter 10 continues in this chapter. Instead of the management profit report format used in the previous two chapters, however, this chapter uses a profit model for each product line. Figure 11.1 presents the profit models for each product line. A profit model is essentially a condensed version, or thumbnail sketch, of the profit reports. Suppose the managers in charge of these three profit mod- ules are seriously considering decreasing their sales prices 10 percent, which they predict would increase sales volume 10 percent. Of course, competitors may reduce their prices 10 percent, so the sales volume increase may not materialize. But the managers don’t think their competitors will follow suit. The company’s products are differentiated from the competi- tion. (Brand names, customer service, and product specifica- tions are types of differentiation.) There always has been some amount of sales price spread between the business’s products and the competition. A 10 percent price cut should not trigger price reductions by competition, in the opinion of the managers. One reason for reducing sales prices is that the business is not selling up to its full capacity. This is not unusual; many businesses have some slack or untapped sales capacity pro- vided by their fixed expenses. In this example, assume that the fixed expenses of each product line provide enough space and personnel to handle a 20 to 25 percent larger sales vol- ume. Spreading total fixed expenses over a larger number of units sold seems like a good idea. Rather than downsizing, which would require cutting fixed expenses, the first thought is to increase sales volume and thus take better advantage of the sales capacity provided by fixed expenses. Of course, the managers are very much aware that salesDANGER! volume may not respond to the reduction in sales price as much as they predict. On the other hand, sales volume may increase more than 10 percent. In any case, they would closely monitor the reaction of customers. Obviously there is a seri- ous risk here. Suppose sales volume doesn’t increase; they may not be able to reverse directions quickly. The managers may not be able to roll back the sales price decrease without losing customers, who may forget the sales price decreases and see the reversal only as price increases.150
  • 159. PRICE/VOLUME TRADE-OFFSBefore the managers make a final decision, wouldn’t it be agood idea to see what would happen to profit? Managersshould run through a quick analysis of the consequences ofthe sales price decision before moving ahead. Otherwise theyare operating in the dark and hoping for the best, which may Standard Product Line Sales price $100.00 Product cost $65.00 Revenue-driven expenses $8.50 Unit-driven expenses $6.50 Unit margin $20.00 Sales volume 100,000 Contribution margin $2,000,000 Fixed operating expenses $1,000,000 Profit $1,000,000 Generic Product Line Sales price $75.00 Product cost $57.00 Revenue-driven expenses $3.00 Unit-driven expenses $5.00 Unit margin $10.00 Sales volume 150,000 Contribution margin $1,500,000 Fixed operating expenses $500,000 Profit $1,000,000 Premier Product Line Sales price $150.00 Product cost $80.00 Revenue-driven expenses $11.25 Unit-driven expenses $8.75 Unit margin $50.00 Sales volume 50,000 Contribution margin $2,500,000 Fixed operating expenses $1,500,000 Profit $1,000,000 FIGURE 11.1 Profit models for three product lines (data from Figure 9.1). 151
  • 160. PROFIT AND CASH FLOW ANALYSIS actually turn out to be the worst. Figure 11.2 presents the analysis of the sales price reduction plan. Whoops! Cutting sales prices would be nothing short of a disaster. Assuming the sales volume predictions turn out to be correct, the sales price reduction would push the generic prod- uct line into the red and cause substantial profit deterioration in the other two product lines. Why is there such a devastating impact on profit? Why would things turn out so badly? For each product line sales price, revenue-driven expenses and sales volume change 10 percent. But the key change is the per- cent decrease in unit margin for each product. For instance, the standard product unit margin would go down a huge 46 percent, from $20.00 to $10.85 (see Figure 11.2). Thus contri- bution margin drops 40 percent and profit drops 81 percent. The puny 10 percent gain in sales volume is not nearly enough to overcome the 46 percent plunge in unit margin. You can’t give up almost half your unit contribution margin and make it back with a 10 percent sales volume increase. In fact, any trade-off that lowers sales price on the one side with an equal percent increase in sales volume on the other side pulls the rug out from under profit. Yet frequently we see sales price reductions of 10 percent or more. What’s going on? First of all, many sales price reduc- tions are from list prices that no one takes seriously as the final price—such as sticker prices on new cars. List prices are only a point of departure for getting to the real price. Every- one wants a discount. I’m sure you’ve heard people say, “I can get it for you wholesale.” The example is based on real prices, or the sales revenue per unit actually received by the business. Can a business cut its real sales price 10 percent and increase profit? Sales vol- ume would have to increase much more than 10 percent, which I explain shortly. Would trading a 10 percent sales price cut for a 10 percent sales volume increase ever be a smart move? It would seem not; we have settled this point in the preceding analysis, haven’t we? Well, there is one exception that brings out an important point. A Special Case: Sunk Costs Notice in Figure 11.1 that the unit costs for the products remain the same at the lower sales price; there are no152
  • 161. PRICE/VOLUME TRADE-OFFS Before After ChangeStandard Product LineSales price $100.00 $90.00 −10%Product cost $65.00 $65.00Revenue-driven expenses $8.50 $7.65 −10%Unit-driven expenses $6.50 $6.50Unit margin $20.00 $10.85 −46%Sales volume 100,000 110,000 10%Contribution margin $2,000,000 $1,193,500 −40%Fixed operating expenses $1,000,000 $1,000,000Profit $1,000,000 $193,500 −81%Generic Product LineSales price $75.00 $67.50 −10%Product cost $57.00 $57.00Revenue-driven expenses $3.00 $2.70 −10%Unit-driven expenses $5.00 $5.00Unit margin $10.00 $2.80 −72%Sales volume 150,000 165,000 10%Contribution margin $1,500,000 $462,000 −69%Fixed operating expenses $500,000 $500,000Profit (Loss) $1,000,000 ($38,000) −104%Premier Product LineSales price $150.00 $135.00 −10%Product cost $80.00 $80.00Revenue-driven expenses $11.25 $10.13 −10%Unit-driven expenses $8.75 $8.75Unit margin $50.00 $36.12 −28%Sales volume 50,000 55,000 10%Contribution margin $2,500,000 $1,986,875 −21%Fixed operating expenses $1,500,000 $1,500,000Profit $1,000,000 $486,875 −51%FIGURE 11.2 10 percent lower sales prices and 10 percent higher salesvolumes. 153
  • 162. PROFIT AND CASH FLOW ANALYSIS changes in the product cost per unit for the product lines. This seems to be a reasonable assumption. To have products for sale, the business either has to buy (or make) them at this unit cost or, if already in inventory, has to incur this cost to replace units sold. This is the normal situation, of course. But it may not be true in certain unusual and nontypical cases. A business may not replace the units sold; it may be at the end of the product’s life cycle. For instance, the product may be in the process of being phased out and replaced with a newer model. In this situation the historical, original account- ing cost of inventory becomes a sunk cost, which means that it’s water over the dam; it can’t be reversed. Suppose the units held in inventory will not be replaced, that the business is at the end of the line on these units and is sell- ing off its remaining stock. In this situation the book value of Y the inventory (the recorded accounting cost) is not relevant. What the business paid in the past for the units should be dis- FL regarded.* For all practical purposes the unit product cost can be set to zero for the units held in stock. The manager should AM ignore the recorded product cost and find the highest sales price that would move all the units out of inventory. TE VOLUME NEEDED TO OFFSET SALES PRICE CUT In analyzing sales price reductions, managers should deter- mine just how much sales volume increase would be needed to offset the 10 percent sales price cut. In other words, what level of sales volume would keep contribution margin the same? For the moment, assume that the fixed expenses would remain the same—that the additional sales volume could be taken on with no increase in fixed costs. The sales volumes needed to keep profit the same for each product line are com- puted by dividing the contribution margins of each product *The original cost (book value) of products that will not be replaced when sold should be written down to a lower value (possibly zero) under the lower-of-cost-or-market (LCM) accounting rule. This write-down is based on the probable disposable value of the products. If such products have not yet been written down, the manager should make the accounting department aware of this situation so that the proper accounting adjusting entry can be recorded.154
  • 163. PRICE/VOLUME TRADE-OFFSline at the original sales prices by the unit margins at thelower sales prices:Product Contribution Margin ÷ Lower Unit Margin = Required Sales VolumeStandard $2,000,000 ÷ $10.85 = 184,332 unitsGeneric $1,500,000 ÷ $2.80 = 535,714 unitsPremier $2,500,000 ÷ $36.12 = 69,204 units Figure 11.3 summarizes the effects of these higher salesvolumes and shows that the number of units sold would haveto increase by rather large percents—from a 257 percentincrease for the generic product line to a 38 percent increasefor the premier product line. Would such large sales volumegains be possible? Doubtful, to say the least. And to achievesuch large increases in sales volume, fixed expenses wouldhave to be increased, probably by quite large amounts. Also,interest expense would increase because more debt would beused to finance the increase in operating assets needed tosupport the higher sales volume.The moral of the story, basically, is that a 10 percent salesprice cut usually takes such a big bite out of unit contributionmargin that it would take a huge increase in sales volume tostay even (i.e., to earn the same profit as before the price cut).Managers should think long and hard before making salesprice reductions.Short-Term and Limited SalesThe preceding analysis applies the sales price reduction to allsales for the entire year. However, many sales price reductionsare limited to a relatively few items and are short-lived, per-haps for only a day or weekend. Furthermore, the sale maybring in customers who buy other items not on sale. Profitmargin is sacrificed on selected items to make additional salesof other products at normal profit margins.Indeed, many retailers seem to have some products on salevirtually every day of the year. In this case the normal profitmargin is hard to pin down, since almost every product takesits turn at being on sale. In short, every product may have twoprofit margins—one when not on sale and one when on sale. 155
  • 164. PROFIT AND CASH FLOW ANALYSIS Before After Change Standard Product Line Sales price $100.00 $90.00 −10% Product cost $65.00 $65.00 Revenue-driven expenses $8.50 $7.65 −10% Unit-driven expenses $6.50 $6.50 Unit margin $20.00 $10.85 −46% Sales volume 100,000 184,332 84% Contribution margin $2,000,000 $2,000,000 Fixed operating expenses $1,000,000 $1,000,000 Profit $1,000,000 $1,000,000 Generic Product Line Sales price $75.00 $67.50 −10% Product cost $57.00 $57.00 Revenue-driven expenses $3.00 $2.70 −10% Unit-driven expenses $5.00 $5.00 Unit margin $10.00 $2.80 −72% Sales volume 150,000 535,714 257% Contribution margin $1,500,000 $1,500,000 Fixed operating expenses $500,000 $500,000 Profit $1,000,000 $1,000,000 Premier Product Line Sales price $150.00 $135.00 −10% Product cost $80.00 $80.00 Revenue-driven expenses $11.25 $10.13 −10% Unit-driven expenses $8.75 $8.75 Unit margin $50.00 $36.12 −28% Sales volume 50,000 69,204 38% Contribution margin $2,500,000 $2,500,000 Fixed operating expenses $1,500,000 $1,500,000 Profit $1,000,000 $1,000,000 FIGURE 11.3 Sales volumes needed to offset 10 percent sales price cuts.156
  • 165. PRICE/VOLUME TRADE-OFFSThe average profit margin for the year depends on how oftenthe item goes on sale. In any case, the same basic analysis also applies to limited,short-term sales price reductions. The manager should calcu-late, or at least estimate, how much additional sales volumewould be needed on the sale items just to remain even withthe profit that would have been earned at normal salesprices. Complicating the picture are sales of other products(not on sale) that would not have been made without theincrease in sales traffic caused by the sale items. Clearly, theadditional sales made at normal profit margins are a big fac-tor to consider, though this may be very hard to estimate withany precision.THINKING IN REVERSE: GIVING UP SALESVOLUME FOR HIGHER SALES PRICESSuppose the general managers of the three product lines arethinking of a general 10 percent sales price increase, knowingthat sales volume probably would decrease. In fact, they pre-dict the number of units sold will drop at least 10 percent.Sales managers generally are very opposed to giving up anysales volume, especially a loss of market share that could bedifficult to recapture later. Any move that decreases sales vol-ume has to be considered very carefully. But for the momentlet’s put aside these warnings. Would a 10 percent sales pricehike be a good move if sales volume dropped only 10 percent? The profit analysis for this trade-off is shown in Figure11.4. However, before you look at it, what would you expect?An increase in profit? Yes, but would you expect the profitincreases to be as large as shown in Figure 11.4? The unitmargins on each product line would increase substantially,from 28 percent on the premier products to 72 percent on thegeneric products. These explosions in unit margins wouldmore than offset the drop in sales volumes and would makefor dramatic increases in profit. Fixed expenses wouldn’t goup with the decrease in sales volume. If anything, some of thefixed operating costs possibly could be reduced at the lowersales volume level. The big jumps in profit reported in Figure 11.4 are basedon the prediction that sales volume would drop only 10 per-cent. But actual sales might fall 15, 20, or even 25 percent. 157
  • 166. PROFIT AND CASH FLOW ANALYSIS Before After Change Standard Product Line Sales price $100.00 $110.00 10% Product cost $65.00 $65.00 Revenue-driven expenses $8.50 $9.35 10% Unit-driven expenses $6.50 $6.50 Unit margin $20.00 $29.15 46% Sales volume 100,000 90,000 −10% Contribution margin $2,000,000 $2,623,500 31% Fixed operating expenses $1,000,000 $1,000,000 Profit $1,000,000 $1,623,500 62% Generic Product Line Sales price $75.00 $82.50 10% Product cost $57.00 $57.00 Revenue-driven expenses $3.00 $3.30 10% Unit-driven expenses $5.00 $5.00 Unit margin $10.00 $17.20 72% Sales volume 150,000 135,000 −10% Contribution margin $1,500,000 $2,322,000 55% Fixed operating expenses $500,000 $500,000 Profit $1,000,000 $1,822,000 82% Premier Product Line Sales price $150.00 $165.00 10% Product cost $80.00 $80.00 Revenue-driven expenses $11.25 $12.38 10% Unit-driven expenses $8.75 $8.75 Unit margin $50.00 $63.87 28% Sales volume 50,000 45,000 −10% Contribution margin $2,500,000 $2,874,375 15% Fixed operating expenses $1,500,000 $1,500,000 Profit $1,000,000 $1,374,375 37% FIGURE 11.4 10 percent higher sales prices and 10 percent lower sales volumes.158
  • 167. PRICE/VOLUME TRADE-OFFSProfit can be calculated for any particular sales volumedecrease prediction, of course. No one knows how sales vol-ume might respond to a 10 percent sales price increase. Salesmay not decrease at all. For instance, the higher prices mightenhance the prestige or upscale image of the standard prod-ucts and attract a more upscale clientele who are quite willingto pay the higher price. Or sales may drop more than 25 per-cent because customers search for better prices elsewhere. How much could sales volume fall and keep total contribu-tion margin the same? This sales volume is computed for thestandard product line as follows: $2,000,000 contribution margin target ᎏᎏᎏᎏᎏ = 68,611 units $29.15 higher unit marginSales volume would have to drop more than 30 percent (from100,000 units in the original scenario to less than 70,000units at the higher sales prices). Sales may not drop off thismuch, at least in the short run. And fixed operating expensesprobably could be reduced at the lower sales volume level. Given a choice, my guess is that the large majority of busi-ness managers would prefer keeping their market share andnot giving up any sales volume, even though profit could bemaximized with higher sales prices and lower sales volumes.Protecting sales volume and market share is deeply ingrainedin the thinking of most business managers. Any loss of market share is taken very seriously. By andlarge, you’ll find that successful companies have built theirsuccess on getting and keeping a significant market share sothat they are a major player and dominant force in the mar-ketplace. True, some companies don’t have a very large marketshare—they carve out a relatively small niche and build theirbusiness on low sales volume at premium prices. The preced-ing analysis for the premier product line demonstrates theprofit potential of this niche strategy, which is built on higherunit margins that more than make up for smaller sales vol-ume.sEND POINTSeldom does one profit factor change without changing orbeing changed by one or more other profit factors. The inter- 159
  • 168. PROFIT AND CASH FLOW ANALYSIS action effects of the changes should be carefully analyzed before making final decisions or locking into a course of action that might be difficult to reverse. Managers should keep their attention riveted on unit margin. Profit performance is most responsive to changes in the unit margin. Basically, there are only two ways to improve unit margin: (1) increase sales price or (2) decrease product cost and/or other variable operating expenses per unit (see Chapter 12). The sales price is the most external or visible part of the business—the factor most exposed to customer reaction. In contrast, product cost and variable expenses are more inter- nal and invisible. Customers may not be aware of decreased expenses unless such cost savings show up in lower product quality or worse service. Last, the importance of protecting sales volume and market share is mentioned in the chapter. Marketing managers know what they’re talking about on this point, that’s for sure. Recapturing lost market share is not easy. Once gone, cus- tomers may never return.160
  • 169. 12 CHAPTERCost/VolumeTrade-Offs andSurvival AnalysisIIt might seem simple enough. Suppose your unit product costgoes up. Then all you have to do is to raise sales price by thesame amount to keep the contribution margin the same, true?Not exactly. Sales volume might be affected by the higherprice, of course. Even if sales volume remained the same, thehigher sales price causes revenue-driven expenses to increase.So it’s more complicated than it might first appear.PRODUCT COST INCREASES: WHICH KIND?There are two quite different reasons for product costincreases. First is inflation, which can be of two sorts. Generalinflation is widespread and drives up costs throughout theeconomy, including those of the products sold by the business.Or inflation may be localized on particular products—forexample, problems in the Middle East may drive up oil andother energy costs; floods in the Midwest may affect corn andsoybean prices. In either situation, the product is the samebut now costs more per unit. The second reason for higher product costs is quite differ-ent than inflation. Increases in unit product costs may reflecteither quality or size improvements. In this situation the prod-uct itself is changed for the better. Customers may be willingto pay more for the improved product, with the result that the 161
  • 170. PROFIT AND CASH FLOW ANALYSIS company would not suffer a decrease in sales volume. Or, if the sales price remains the same on the improved product, then sales volume may increase. Customers tend to accept higher sales prices if they per- ceive that the company is operating in a general inflationary market environment, when everything is going up. On a com- parative basis, the product does not cost more relative to price increases of other products they purchase. Sales volume may not be affected by higher sales prices in a market dominated by the inflation mentality. On the other hand, if customers’ incomes are not rising in proportion to sales price increases, demand would likely decrease at the higher sales prices. If competitors face the same general inflation of product costs, the company’s sales volume may not suffer from pass- ing along product cost increases in the form of higher sales prices because the competition would be doing the same thing. The exact demand sensitivity to sales price increases cannot be known except in hindsight. Even then, it’s difficult to know for sure, because many factors change simultane- ously in the real world. Whenever sales prices are increased due to increases in prod- uct costs—whether because of general or specific inflation or product improvements—managers cannot simply tack on the product cost increase to sales price. They should carefully take into account variable expenses that are dependent on (driven by) sales revenue. To illustrate this point, consider the standard product line example from previous chapters. The sales price and per-unit costs for the product are as follows (from Figure 9.1). Standard Product Sales price $100.00 Product cost $ 65.00 Revenue-driven expenses @ 8.5% $ 8.50 Unit-driven expenses $ 6.50 Unit margin $ 20.00 Suppose, for instance, that the company’s unit product cost goes up $9.15, from $65.00 to $74.15 per unit. (This is a162
  • 171. COST/VOLUME TRADE-OFFSrather large jump in cost, of course.) The manager shouldn’tsimply raise the sales price by $9.15. In the example, therevenue-driven variable operating expenses are 8.5 percentof sales revenue. So the necessary increase in the sales priceis determined as follows: $9.15 product cost increase ᎏᎏᎏᎏ = $10.00 sales price increase 0.915Dividing by 0.915 recognizes that only 91.5 cents of a salesdollar is left over after deducting revenue-driven variableexpenses, which equal 8.5 cents of the sales dollar. Only 91.5cents on the dollar is available to provide for the increase inthe unit product cost. If the business raises its sales priceexactly $10.00 (from $100.00 to $110.00), the unit margin forthe standard product would remain exactly the same, which isshown as follows: Standard Product Sales Price for Higher Product Cost Sales price $110.00 Product cost $ 74.15 Revenue-driven expenses @ 8.5% $ 9.35 Unit-driven expenses $ 6.50 Unit margin $ 20.00 Therefore the company’s total contribution margin wouldbe the same at the $110.00 sales price, assuming sales vol-ume remains the same, of course.VARIABLE COST INCREASES AND SALES VOLUMEAs just mentioned, one basic type of product cost increaseoccurs when the product itself is improved. These qualityimprovements may be part of the marketing strategy to stim-ulate demand by giving customers a better product at thesame sales price. In addition to product cost, one or more ofthe specific variable operating expenses could be deliber-ately increased to improve the quality of the service to cus-tomers. For example, faster delivery methods such as overnightFederal Express could be used, even though this would cost 163
  • 172. PROFIT AND CASH FLOW ANALYSIS more than the traditional delivery methods. This would increase the volume-driven expense. The company could increase sales commissions to improve the personal time and effort the sales staff spends with each customer, which would increase the revenue-driven expense. In our example, suppose the general manager of the stan- dard product line is considering a new strategy for product and service quality improvements that would increase product cost and unit-driven operating expenses 4 percent. Revenue- driven variable expenses would be kept the same, or 8.5 per- cent of sales revenue. Tentatively, she has decided not to increase sales prices because in her opinion the improved products and service would stimulate demand for these prod- ucts. It goes without saying that customers would have to be aware of and convinced that the product has improved. Before making a final decision, she asks the critical question: What increase in sales volume would be necessary just to Y keep profit the same? FL Figure 12.1 presents this even-up, or standstill, scenario in which product cost and unit-driven variable expenses increase 4 percent but sales price remains the same. Fixed AM expenses are held constant, as is the variable revenue-driven operating expenses. Sales volume would have to increase 16,686 units, or 16.7 percent. By the way, the required sales TE Standard Product Line Before After Change Sales price $100.00 $100.00 Product cost $65.00 $67.60 4.0% Revenue-driven expenses $8.50 $8.50 Unit-driven expenses $6.50 $6.76 4.0% Unit margin $20.00 $17.14 −14.3% Sales volume 100,000 116,686 16.7% Contribution margin $2,000,000 $2,000,000 Fixed operating expenses $1,000,000 $1,000,000 Profit $1,000,000 $1,000,000 FIGURE 12.1 Sales volume required for a 4 percent cost increase.164
  • 173. COST/VOLUME TRADE-OFFSvolume for this scenario of higher cost and lower unit margincan be computed directly as follows:Required Sales Volume at Higher Costs$2,000,000 contribution margin targetᎏᎏᎏᎏᎏ $17.14 lower unit margin = 116,686 sales volumeThe relatively large increase in sales volume needed to offsetthe relatively minor 4 percent cost increase is because the costincrease causes a 14.3 percent drop in unit margin. So a 16.7percent jump in sales volume would be needed to keep profitat the same level. The key point is the drop in the unit margincaused by the cost increase. It takes a large increase in salesvolume to make up for the drop in the unit margin. There is more bad news. More capital would be needed atthe higher sales volume level; the capital invested in assetswould be higher due mainly to increases in accounts receiv-able and inventory. The impact on cash flow at the highersales volume level is explained in Chapter 13.BETTER PRODUCT AND SERVICE PERMITTINGHIGHER SALES PRICEThe alternative to selling more units to overcome the costincreases is to sell the same number of units at a higher salesprice. Figure 12.2 presents the higher sales price that wouldkeep profit the same as before, given the 4 percent higherproduct cost and 4 percent higher unit-driven variableexpenses. In this scenario the cost increase is loaded into thesales price and is not reflected in a sales volume increase. Following this strategy, the sales price would be increasedto $103.13 (rounded).* In this case the business improved theproduct and the service to its customers. There is no increasein profit. This product upgrade would be customer-driven—if*The required sales price is computed as follows: ($67.60 product cost +$6.76 unit-driven cost + $20.00 unit margin) ÷ (1.000 − 0.085) = $103.13sales price (rounded). In other words, the sales price, net of the revenue-driven cost per unit as a percent of sales price, must cover the product costand the sales volume–driven expense per unit and provide the same unitmargin as before. 165
  • 174. PROFIT AND CASH FLOW ANALYSIS Standard Product Line Before After Change Sales price $100.00 $103.13 3.1% Product cost $65.00 $67.60 4.0% Revenue-driven expenses $8.50 $8.77 Unit-driven expenses $6.50 $6.76 4.0% Unit margin $20.00 $20.00 Sales volume 100,000 100,000 Contribution margin $2,000,000 $2,000,000 Fixed operating expenses $1,000,000 $1,000,000 Profit $1,000,000 $1,000,000 FIGURE 12.2 Higher sales price required for a 4 percent cost increase the company failed to improve its product and/or service, then it might lose sales, because the customers want the improve- ments and are willing to pay. This may seem to be a strange state of affairs, but you see examples every day where the cus- tomer wants a better product and/or service and is willing to pay more for the improvements. LOWER COSTS: THE GOOD AND BAD Suppose a business were able to lower its unit product costs and its variable expenses per unit. On the one hand, such cost savings could be true efficiency or productivity gains. Sharper bargaining may reduce purchase costs, for example, or better manufacturing methods may reduce labor cost per unit pro- duced. Wasteful fixed overhead costs could be eliminated or slashed. The key question is whether the company’s products remain the same, whether the products’ perceived quality remains the same, and whether the quality of service to cus- tomers remains the same. Maybe not. Product cost decreases may represent quality degradations, or possibly reduced sizes such as smaller candy bars or fewer ounces in breakfast cereal boxes. Reducing vari- able operating expenses may adversely affect the quality of service to customers—for instance, by spreading fewer per- sonnel over the same number of customers.166
  • 175. COST/VOLUME TRADE-OFFSLower Costs and Higher Unit MarginIf the company can lower its costs and still deliver the sameproduct and the same quality of service, then sales volumeshould not be affected (everything else remaining the same, ofcourse). Customers should see no differences in the productsor service. In this case the cost savings would improve unitmargins and profit would increase accordingly. Improvements in the unit margins are very powerful; theseincreases have the same type of multiplier effect as the oper-ating leverage of selling more units. For example, supposethat because of true efficiency gains the business is able tolower product costs and unit-driven expenses such that unitmargin on its standard product line is improved, say, $1.00per unit. Now this may not seem like much, but rememberthat the business sells 100,000 units during the year. Therefore, the $1.00 improvement in unit margin wouldadd $100,000 to the contribution margin line, which is a 5percent gain on its original $2 million contribution margin.Lowering product cost and the unit-driven operating costsshould not cause fixed costs to change, so all of the $100,000contribution margin gain would fall to profit. The $100,000gain in profit is a 10 percent increase on the $1 million origi-nal profit, or double the 5 percent gain in contribution margin. Total quality management (TQM) is getting a lot of presstoday, indicated by the fact that it has been reduced to anacronym. Clearly, managers have always known that productquality and quality of service to customers are absolutely criti-cal factors, though perhaps they lost sight of this in pursuit ofshort-term profits. Today, however, managers obviously havebeen made acutely aware of how quality conscious customersare (though I find it surprising that today’s gurus are preach-ing this gospel as if it were just discovered).Lower Costs Causing Lower Sales VolumeCost savings may cause degradation in the quality of the prod-uct or service to customers. It would be no surprise, therefore,if sales volume would decrease. The unit margin wouldimprove, but sales volume may drop as some customers aban-don the business because of poorer product quality. Still, abusiness might adopt the strategy of deliberately knockingdown the quality of its products (or some of its products) and 167
  • 176. PROFIT AND CASH FLOW ANALYSIS the general level of service to its customers to boost unit mar- gin, gambling that the higher unit margin will more than offset the loss of sales volume. (Of course, this brings up the loss-of- market-share problem again, which I won’t go into here.) To illustrate this scenario of lower cost and lower sales vol- ume, suppose the business could lower the product costs in its standard product line from $65.00 to $60.00 per unit, but this cost savings results in lesser-grade materials, cheaper trim, and so forth. And the company could save on its shipping costs and reduce its unit-driven variable costs from $6.50 to $5.00 per unit, but in exchange delivery time to the customers would take longer. The combined $6.50 cost savings would increase unit margin by the same amount. The general man- ager of this profit module knows that many customers will be driven off by the changes in product quality and delivery times. She wants to know just how far sales volume would have to fall to offset the $6.50 gain in unit margin. Figure 12.3 shows that if sales volume fell to 75,472 units, profit would be the same. In other words, selling 75,472 units at a $26.50 unit margin each would generate the same con- tribution margin as before. If sales fell by only 10,000 or 15,000 units, profit would be more than before. And, cer- tainly, fixed costs would not go up at the lower sales volume. If anything, fixed costs probably could be reduced at the lower sales volume. Standard Product Line Before After Change Sales price $100.00 $100.00 Product cost $65.00 $60.00 −7.7% Revenue-driven expenses $8.50 $8.50 Unit-driven expenses $6.50 $5.00 −23.1% Unit margin $20.00 $26.50 32.5% Sales volume 100,000 75,472 −24.5% Contribution margin $2,000,000 $2,000,000 Fixed operating expenses $1,000,000 $1,000,000 Profit $1,000,000 $1,000,000 FIGURE 12.3 Lower costs causing lower sales volume.168
  • 177. COST/VOLUME TRADE-OFFSThis sort of profit strategy goes against the grain of manymanagers. Of course, the business could lose more than 25percent of sales volume, in which case its profit would belower than before. Once a product becomes identified as alow-cost/low-quality brand, it’s virtually impossible to reversethis image in the minds of most customers. Thus, it’s no sur-prise why many managers take a dim view of this profit strat-egy.SUBTLE AND NOT-SO-SUBTLE CHANGESIN FIXED COSTSWhy do fixed operating expenses increase? The increase maybe due to general inflationary trends. For instance, utility billsand insurance premiums seem to drift relentlessly upward;they hardly ever go down. In contrast, fixed operatingexpenses may be deliberately increased to expand capacity.The business could rent a larger space or hire more employ-ees on fixed salaries. And there’s a third reason: Fixed expenses may beincreased to improve the sales value of the present location.The business could invest in better furnishings and equipment(which would increase its annual depreciation expense). Fixedexpenses could decrease for the opposite reasons, of course.But, we’ll focus on increases in fixed expenses. Suppose in the company example that total fixed operatingexpenses were to increase due to general inflationary trends.There were no changes in the capacity of the business or inthe retail space or appearance (attractiveness) of the space. Asfar as customers can tell there have been no changes thatwould benefit them. The company could attempt to increaseits sales price—the additional fixed expenses could be spreadover its present sales volume. However, this assumes sales volume would remain thesame at the higher sales price. Sales volume might decreaseat the higher sales price unless customers accept the increaseas a general inflationary-driven increase. Sales volume mightbe sensitive to even small sales price increases. Many cus-tomers keep a sharp eye on prices, as you know. The businessshould probably allow for some decrease in sales volumewhen sales prices are raised. 169
  • 178. PROFIT AND CASH FLOW ANALYSIS SURVIVAL ANALYSIS As I recall, many years ago there was a series in a magazine called “Can This Marriage Be Saved?” Which is not a bad way to introduce the situation in which any business can find itself from time to time—selling a product or product line that is losing money hand over fist. Perhaps the entire business is in dire straits and can’t make money on any of its products. Before throwing in the towel, the manager in charge should at least do the sort of analysis explained in this chapter to deter- mine what would have to be done to salvage the product or keep the business going. Profile of a Loser A successful formula for making profit can take a wrong turn anytime. Every step on the pathway to profit is slippery and requires constant attention. Managers have to keep a close watch on all profit factors, continuously looking for opportuni- ties to improve profit. Nothing can be taken for granted. A popular term these days is environmental scan, which is a good term to use here. Managers should scan the profit radar to see if there are any blips on the screen that signal trouble. Suppose you’re the manager in charge of a product line, territory, division, or some other major organization unit of a large corporation. You are responsible for the profit perform- ance of your unit, of course. A brief summary of your most recent annual profit report is presented in Figure 12.4, which is titled the Bad News Profit Report to emphasize the loss for the year. This report is shown in a condensed format to limit attention to absolutely essential profit factors. Only one vari- able operating expense is included (which is unit-driven). The examples in this and previous chapters also include revenue- driven variable operating expenses, but this distinction takes a backseat in the following analysis. In addition to sales volume, note that the example also includes annual capacity and breakeven volume for the year just ended. You have taken a lot of heat lately from headquarters for the $145,000 loss. Your job is to turn things around—and fairly fast. Your bonus next year, and perhaps even your job, depends on moving your unit into the black.170
  • 179. COST/VOLUME TRADE-OFFS Annual sales 100,000 units Annual breakeven 120,000 units Annual capacity 150,000 units Per Unit Total Sales revenue $50.00 $5,000,000 Product cost ($32.50) ($3,250,000) Variable expenses ($10.25) ($1,025,000) Contribution margin $ 7.25 $ 725,000 Fixed operating expenses ($ 870,000) Profit (loss) ($ 145,000) Breakeven is computed by dividing $870,000 fixed expenses by $7.25 contribution margin per unit. Annual capacity is new information given here in the example.FIGURE 12.4 Bad news profit report.First Some Questions about Fixed ExpensesOne thing you might do first is to take a close look at your$870,000 fixed operating expenses. Your fixed expenses mayinclude an allocated amount from a larger pool of fixedexpenses generated by the organizational unit to which yourprofit module reports, or they may include a share of fixedexpenses from corporate headquarters. Any basis of allocationis open to question; virtually every allocation method is some-what arbitrary and can be challenged on one or moregrounds. For instance, consider the legal expenses of the corpora-tion. Should these be allocated to each profit responsibilityunit throughout the organization? On what basis? Relativesales revenue, frequency of litigation of each unit, or accord-ing to some other formula? Likewise, what about the costs ofcentralized data processing and accounting expenses of thebusiness? Many fixed expenses are allocated on some arbi-trary basis, which is open to question. 171
  • 180. PROFIT AND CASH FLOW ANALYSIS It’s not unusual for many costs to be allocated across differ- ent organizational units; every manager should be aware of the methods, bases, or formulas that are used to allocate costs. It is a mistake to assume that there is some natural or objective basis for cost allocation. Most cost allocation schemes are arbitrary and therefore subject to manipulation. Chapter 17 discusses cost allocation schemes in more detail. Questions about the proper method of allocation should be settled before the start of the year. Raising such questions after the fact—after the profit performance results are reported for the period—is too late. In any case, if you argue for a smaller allocation of fixed expenses to your unit, then you are also arguing that other units should be assessed a greater proportion of the organization’s fixed expenses— which will initiate a counterargument from those units, of course. Also, it may appear that you’re making excuses rather than fixing the problem. Another question to consider is this: Is a significant amount of depreciation expense included in the fixed expenses total? Accountants treat depreciation as a fixed expense, based on generally accepted methods that allocate original cost over the estimated useful economic lives of the assets. For instance, under current income tax laws, buildings are depreciated over 39 years and cars and light trucks over 5 years. Just because accountants adopt such methods doesn’t mean that deprecia- tion is, in fact, a fixed expense. Contrast depreciation with, for example, annual property taxes on buildings and land (real estate). Property tax is an actual cash outlay each year. Whether or not the business made full use of the building and land during the year, the entire amount of tax should be charged to the year as fixed expense. There can be no argument about this. On the other hand, depreciation raises entirely different issues. Suppose your loss is due primarily to sales volume that is well below your normal volume of operations. You can argue that less depreciation expense should be charged to the year and more shifted to future years. The reasoning is that the assets were not used as much—the machines were not oper- ated as many hours, the trucks were not driven as many miles, and so on. On the other hand, depreciation may be truly caused by the passage of time. For instance, deprecia- tion of computers is based on their expected technological life.172
  • 181. COST/VOLUME TRADE-OFFSUsing the computers less probably doesn’t delay the date ofreplacing the computers. Generally speaking, arguing for less depreciation is notgoing to get you very far. Most businesses are not willing tomake such a radical change in their depreciation policies (i.e.,to slow down recorded depreciation when sales volume takesa dip). Also, this would look suspicious—the business wouldappear to be choosing expense methods to manipulatereported profit.What’s the Problem?Your first thought might be that sales volume is the main prob-lem since it is below your breakeven point (see Figure 12.4). Toreview briefly, the breakeven point is determined as follows:$870,000 fixed expensesᎏᎏᎏ = 120,000 units breakeven volume $7.25 unit margin To reach breakeven (the zero profit and zero loss point) youwould have to sell an additional 20,000 units, which wouldadd $145,000 additional contribution margin at a $7.25 unitmargin. By the way, notice that breakeven is 80 percent ofcapacity (120,000 units sold ÷ 150,000 units capacity = 80%).By almost any standard, this is far too high. Anyway, justreaching the breakeven point is not your ultimate goal, thoughit would be better than being in the red. Suppose you were able to increase sales volume beyond thebreakeven point, all the way up to sales capacity of 150,000units, an increase of 50,000 units from the actual sales level of100,000 units. A 50 percent increase in sales volume may notbe very realistic, to say the least. At any rate, your annualprofit report would appear as shown in Figure 12.5. Even if your sales volume could be increased to full capac-ity, profit would be only $217,500, which equals only 2.9 per-cent of sales revenue. For the large majority of businesses—the only exceptions being those with very high inventoryturnover ratios—a meager 2.9 percent return on sales is seri-ously inadequate. Your return-on-sales profit goal probablyshould be in the range of 10 to 15 percent. In short, increasing sales volume is not the entire answer.You have two other basic options: Reduce fixed expenses orimprove unit margin. 173
  • 182. PROFIT AND CASH FLOW ANALYSIS Annual sales 150,000 units Annual breakeven 120,000 units Annual capacity 150,000 units Per Unit Total Sales revenue $50.00 $7,500,000 Product cost ($32.50) ($4,875,000) Variable expenses ($10.25) ($1,537,500) Contribution margin $ 7.25 $1,087,500 Fixed operating expenses ($ 870,000) Profit (loss) $ 217,500 Notice that even at full capacity, profit is only 2.9 percent of sales revenue, which in almost all industries is far too low. FIGURE 12.5 Sales at full capacity profit report. Y FL There may be flab in your fixed expenses. It goes without AM saying that you should cut the fat. The more serious question is whether to downsize (reduce fixed operating expenses and capacity). For instance, assume you could slash fixed TE expenses by one-third ($290,000) but that this would reduce capacity by one-third, down to 100,000 units. If no other fac- tors change, your profit performance would be as shown in Figure 12.6. Your profit would be $145,000, which is better than a loss. But profit would still be only 2.9 percent of sales rev- enue, which is much too low as already explained. Keep in mind that making profit requires a substantial amount of capital invested in the assets needed to carry on profit- making operations. The capital invested in assets is supplied by debt and equity sources and carries a cost (as discussed in Chapter 6). Suppose, to illustrate this cost-of-capital point, that the $5 million sales revenue level requires investing $2 million in assets—one-half from debt at 8.0 percent annual interest and one-half from equity on which the annual ROE target is 15.0 percent. The interest expense is $80,000 ($1 million debt × 8.0%), leaving only $65,000 earnings before tax. Net income174
  • 183. COST/VOLUME TRADE-OFFS Annual sales 100,000 units Annual breakeven 80,000 units Annual capacity 100,000 units Per Unit Total Sales revenue $50.00 $5,000,000 Product cost ($32.50) ($3,250,000) Variable expenses ($10.25) ($1,025,000) Contribution margin $ 7.25 $ 725,000 Fixed operating expenses ($ 580,000) Profit (loss) $ 145,000 Notice that even if fixed expenses are reduced by one- third, profit is only 2.9 percent of sales revenue, which in almost all industries is far too low.FIGURE 12.6 Profit at one-third less fixed costs and capacity.after income tax is not enough to meet the company’s ROEgoal, which would be the $1 million owners’ equity capitaltimes 15.0 percent, or $150,000 net income. By cutting fixed operating expenses you have removed anyroom for growth, because sales volume would be at capacity.In summary, it’s fairly clear that your main problem is a unitcontribution margin that is too low.Improving Unit MarginNow for the tough question: How would you improve unitmargin? Is sales price too low? Are product cost and variableexpenses too high? Do all three need improving? Answeringthese questions strikes at the essence of the manager’s func-tion. Managers are paid for knowing what to do, what has tobe changed, and how to make the changes. Analysis tech-niques don’t provide the final answers to these questions. Butthe analysis methods certainly help the manager size up andquantify the impact of changes in factors that determine unitcontribution margin. One useful approach is to set a reasonably achievable profit 175
  • 184. PROFIT AND CASH FLOW ANALYSIS goal—say $500,000—and load all the needed improvement on each factor to see how much change would be needed in each. To move from $145,000 loss to $500,000 profit is a $645,000 swing. If sales volume stays the same at 100,000 units, then achieving this improvement would require that the unit mar- gin be increased $6.45 per unit, which is a tall order. You could compare the $6.45 unit margin increase to each profit factor; doing this shows that the following improvement per- cents would be needed: Unit Margin Improvement as Percent of Each Profit Factor $6.45 ÷ $50.00 sales price = 13 percent increase $6.45 ÷ $32.50 product cost = 20 percent decrease $6.45 ÷ $10.25 variable expenses = 63 percent decrease Making changes of these magnitudes would be very tough, to say the least. Raising sales prices 13 percent would surely depressDANGER! demand. Lowering product cost 20 percent is not realistic in most situations. And lowering variable expenses 63 percent may be just plain impossible. A combination of improvements would be needed instead of loading all the improvement on just one factor. Also, sales volume probably would have to be increased. Suppose you develop the following plan: Sales prices will be increased 5 percent and sales volume will be increased 10 percent (based on better marketing and advertising strate- gies). Product cost will be reduced 4 percent by sharper pur- chasing, and variable expenses will be cut 8 percent by exercising tighter control over these expenses. Last, you think you can eliminate about 10 percent fat from fixed expenses (without reducing sales capacity). If you could actually achieve all these goals, your profit report would look as shown in Fig- ure 12.7. You would make your profit goal and then some, but only if all the improvements were actually achieved. Profit would be 9.1 percent of sales revenue ($522,700 profit ÷ $5,775,000 sales revenue = 9.1 percent). This plan may or may not be achievable. You may have to go back to the drawing board to figure out additional improvements.176
  • 185. COST/VOLUME TRADE-OFFS Annual sales 110,000 units Annual breakevenn 65,965 units Annual capacity 150,000 units Per Unit Total Sales revenue $52.50 $5,775,000 Product cost ($31.20) ($3,432,000) Variable expenses ($ 9.43) ($1,037,300) Contribution margin $11.87 $1,305,700 Fixed operating expenses ($ 783,000) Profit (loss) $ 522,700FIGURE 12.7 Profit improvement plan.sEND POINTChapters 11 and 12 examine certain basic trade-offs; bothchapters rest on the premise that seldom does one profit fac-tor change without changing or being changed by one or moreother profit factors. Mentioned earlier but worth repeatinghere is that managers must keep their attention riveted onunit contribution margin. Profit performance is very sensitiveto changes in this key operating profit number, as demon-strated by several different situations in Chapters 11 and 12. Chapter 11 examines the interplay between sales price andvolume changes. Sales prices are the most external part of thebusiness. In contrast, product cost and variable expenses (thesubject of this chapter) are more internal to the business. Cus-tomers may not be aware of these expense decreases unlesssuch cost savings show through in lower product quality orworse service. Frequently, cost savings are not cost savings atall, in the sense that customer demand is adversely affected. Cost increases can be caused by inflation (general or spe-cific), by product improvements in size or quality, or by thequality of service surrounding the product. To prevent profitdeterioration, cost increases have to be recovered throughhigher sales volume or through higher sales prices. This 177
  • 186. PROFIT AND CASH FLOW ANALYSIS chapter examines the critical differences between these two alternatives. Depending on higher sales volume to compensate for cost increases may not be very realistic; sales volume would have to increase too much. This type of analysis does give man- agers a useful point of reference, however. Cost increases gen- erally have to be recovered through higher sales prices. This chapter demonstrates the analysis tools for determining the higher sales prices.178
  • 187. 13 CHAPTER Profit Gushes: Cash Flow Trickles?Y You’d probably assume that if profit improved, say, $200,000 next year, then cash flow from profit would increase $200,000 during the year. Not true. In most cases the increase in cash flow from profit would be less. The cash flow shortfall may be rather insignificant and not worth worrying about too much. But the lag in cash flow from increasing profit often is quite significant. This chapter demonstrates one basic point that business man- agers should have clear in their minds: Certain ways of improving profit have much better cash flow benefits than others. The preceding four chapters analyze and demonstrate the ways a business can improve its profit, which on the flip side are the ways a business can see profit slip away. Hardly anything has been mentioned about changes in cash flow caused by changes in profit. The moral of this chapter is, don’t count your cash flow chickens until the eggs are hatched! A LESSONS FROM CHAPTER 2Remember Chapter 2 explains accrual-basis accounting, necessary to measure profit, which is more complex than simply recording cash collections from sales and cash payments for expenses. Accrual-basis accounting entails the following: 179
  • 188. PROFIT AND CASH FLOW ANALYSIS • Recording revenue from credit sales before the cash is col- lected from customers at a later time • Recording certain expenses before the costs are paid at a later time • Recording certain expenses after the costs are paid at an earlier time • Waiting to record the expense for cost of products sold to customers until the sale is recorded, even though the prod- ucts are paid for before they are sold • Recording depreciation expense for using long-term operat- ing assets over the several years of their use, even though the assets are paid for before they are used For the most part, cash flows in from sales and out for expenses occur at different times than when sales revenue and expenses are recorded. To correctly measure profit, a business cannot use cash-basis accounting and must use accrual-basis accounting. More work, but a truer profit measure. The amounts reported in the external income statements of a business to its creditors and shareowners and in its internal profit reports to managers are all accrual-basis accounting numbers. These numbers do not equal the actual amounts of cash flows during the period. The actual cash flows during the period are higher or lower than the corresponding accrual- basis numbers. The bottom-line cash flow from profit during the period can be very different from bottom-line profit. Busi- ness managers need bifocal lenses when focusing on profit versus cash flow from profit. CASH FLOW FROM BOOSTING SALES VOLUMES The analysis of changes in profit over the preceding four chapters deals with changes in sales revenue and expenses. These changes are accrual-basis numbers, not cash flow num- bers. Let’s return to the first scenario from Chapter 9, in which sales volume (the number of units sold over the year) increases 10 percent. Figure 13.1 summarizes the changes in sales revenue and expenses for each of the three product lines in the example. The amounts of changes presented in Figure 13.1 are accrual-basis accounting numbers. For instance, the $1 mil- lion sales revenue increase for the standard product is the180
  • 189. PROFIT GUSHES: CASH FLOW TRICKLES? Standard Product Line ChangesSales revenue $1,000,000Cost of goods sold $ 650,000Gross margin $ 350,000Revenue-driven expenses @ 8.5% $ 85,000Unit-driven expenses $ 65,000Contribution margin $ 200,000Fixed operating expenses $ 0Profit $ 200,000 Generic Product Line ChangesSales revenue $1,125,000Cost of goods sold $ 855,000Gross margin $ 270,000Revenue-driven expenses @ 4.0% $ 45,000Unit-driven expenses $ 75,000Contribution margin $ 150,000Fixed operating expenses $ 0Profit $ 150,000 Premier Product Line ChangesSales revenue $ 750,000Cost of goods sold $ 400,000Gross margin $ 350,000Revenue-driven expenses @ 7.5% $ 56,250Unit-driven expenses $ 43,750Contribution margin $ 250,000Fixed operating expenses $ 0Profit $ 250,000FIGURE 13.1 Changes in sales revenue and expenses from highersales volumes (data from Figure 9.2). 181
  • 190. PROFIT AND CASH FLOW ANALYSIS amount of additional sales revenue that would be recorded if the business sells 10 percent more units. If the business made all sales for cash on the barrelhead and did not extend credit to its customers there would be a one-to-one correspondence between the amount of the accrual-basis sales revenue recorded during the period and the cash flow from sales rev- enue during the period. Cash Inflow from Sales Revenue Increase The business in the example extends credit to its customers. If next year the business sells 10 percent more units of the stan- dard product line at the same sales prices, then sales revenue would increase $1 million. But this doesn’t mean that the business will collect $1 million additional cash from its cus- tomers during the year. Cash inflow from the additional sales revenue would be less. Customers are offered one month of credit before they have to pay the business. Thus the actual cash inflow from the additional sales would be less than $1 million because sales made during the last month of the year would not be collected by the end of the year. During the year the business would collect 11 months of the additional sales revenue, but not the final, twelfth month. Assuming sales are level during the year, the business would collect 11⁄12 of the $1 million additional sales revenue ($1 mil- lion additional sales revenue × 11⁄12 = $916,667 cash collections during the year). The remainder wouldn’t be collected until the early part of the following year. In short, there is a one- month lag in collecting sales made on credit. Cash Outflows for Expense Increases Expenses are a little more complicated than sales revenue from the cash flow point of view. First is cost-of-goods-sold expense. In the 10 percent higher sales volume scenario, cost- of-goods-sold expense increases $650,000 for the standard product line (see Figure 13.1). You might assume that cash outlays would also increase $650,000. Actually, cash outflow would be more than this because the business would increase its inventory of standard products to support the higher sales level. In addition to paying for units sold, the business would182
  • 191. PROFIT GUSHES: CASH FLOW TRICKLES?build up its inventory, which requires additional cash outlay.As a general rule, selling more units means that a businessmust have more units on hand to sell. It’s possible that a busi-ness could sell 10 percent more units without increasing itsinventory. But generally speaking, inventory rises more or lessproportionally with a rise in sales volume. A business either manufactures the products it sells or itpurchases the products it sells from other businesses. Ineither case, an increase in inventory usually involves a cor-responding increase in accounts payable. Raw materialsused in the production process are purchased on credit, andmany other manufacturing costs are not paid for immedi-ately. Products from other businesses are bought on credit.Instead of making immediate cash payment when inventoryis increased, a business delays payment, perhaps by a monthor so. However, vendors and suppliers are not willing to extendcredit and wait for payment until the buyer sells the products.They won’t wait out the entire inventory-holding period; theywant their money sooner than that. That is, the business’sinventory-holding period is longer than the credit period of itsaccounts payable. In this example, the business holds prod-ucts in inventory for two months on average before they aresold and delivered to customers. The average credit period ofits inventory-driven accounts payable is only one month. Thebusiness has to make cash payment for the second month ofholding inventory. At the end of the year the business’s inventory is twomonths higher for the additional layer of sales—one monthunpaid (reflected in the increase of accounts payable) and onemonth paid. The business paid for the 12 months of productssold plus an additional month for the increase in inventory. Inshort, the cash outlay for inventory for the increase in salesvolume of the standard product line is $704,167 ($650,000additional cost of goods sold expense for the year × 13⁄12 =$704,167 cash outlay for cost of goods sold and inventorybuildup). When sales volume increases, variable expenses alsoincrease (see Figure 13.1). Both revenue-driven and unit-driven variable expenses increase for all three of the productlines. Of course, this is the very definition of variableexpenses—costs that go up and down with increases and 183
  • 192. PROFIT AND CASH FLOW ANALYSIS decreases in sales. Many variable operating expenses are not paid until a month or more after the expenses are recorded. The obligations for these unpaid expenses are recorded in two liability accounts—accounts payable and accrued expenses payable. For most businesses, the amounts of their accounts payable for unpaid operating expenses and accrued expenses payable are fairly significant amounts. To expedite matters, assume that there is a one-month delay, or lag, in paying variable operating expenses. This is in the ballpark for many busi- nesses. For each $12.00 of increase in variable operating expenses, assume the business pays only $11.00 during the year. The other dollar will be paid in the early part of the fol- lowing year. For example, in the sales volume increase sce- nario, unit-driven variable operating expenses for the standard product line increase $65,000 (see Figure 13.1). Thus the cash outlay during the year for this increase is $59,583 ($65,000 Y additional expenses × 11⁄12 = $59,583 cash outlay). FL Summing Up the Cash Flow Effects AM The differences between cash flows and the accrual-basis amounts of changes in sales revenue and expenses for the year caused by increasing sales volume are summarized as follows: TE • There is a one-month lag in collecting sales revenue because the business sells on credit, so only 11⁄12 of the increase in sales revenue is collected in cash through the end of the year. • The sales volume increase requires a corresponding increase in inventories that is equal to two months, or 2⁄12, of the cost-of-goods-sold increase; accounts payable for invento- ries also increase, equal to one month of the increase in inventories. So the cash outlay for the inventories increase is only 1⁄12 of the cost of goods sold increase. • There is a one-month lag in paying variable operating expenses, so only 11⁄12 of the increase in operating expenses is paid in cash through the end of the year. Basically there is a one-month time differential between the accrual-basis changes in sales revenue and expenses and the cash flows in from sales and out for expenses. There is a184
  • 193. PROFIT GUSHES: CASH FLOW TRICKLES?one-month cash flow delay from the sales revenue increase, aone-month additional cash outlay for the cost of goods soldincrease, and a one-month delay in paying the variableexpenses increase. This one-month shift is fairly realistic formany businesses; it certainly moves the accrual-basis num-bers much closer to when actual cash flows occur.CASH FLOWS ACROSS DIFFERENT PRODUCT LINESFigure 13.2 presents the cash flow effects from increasingsales volume 10 percent for the three product lines of thebusiness. I’d wager that the cash flow effects, especially forthe generic product line, surprise you. If not, you’d better takea closer look at Figure 13.2. The best cash flow result is for the premier product line,but even here the cash flow increase for the year would beonly $162,500 compared with the $250,000 profit increase.For the standard product line, the cash flow yield is only$75,000 for a $200,000 gain in profit, and cash flow actuallydecreases $5,000 for the generic product line, even thoughprofit increases $150,000. For each of the product lines, the delay in collecting theincrease in sales revenue combined with the cash outlay forincreasing inventories puts a double whammy on cash flow.The slim margin on the generic products means that the costof goods sold is a relatively high proportion of sales revenue.So the increase in inventories puts a particularly large demandon cash to be invested in inventories at the higher sales vol-ume level. The premier product is just the reverse. The highmargin on these products means that the increase in invento-ries does not do as much damage to cash flow.CASH FLOW FROM BUMPING UP SALES PRICESChapter 10 examines the profit effects from increasing salesprices, holding all other profit factors constant. The profitgains are much more favorable compared with increasingsales volume the same percent, as explained in Chapter 10.The cash flow effects of a 10 percent sales price increase arealso much more favorable. Figure 13.3 presents the cash floweffects from increasing sales prices 10 percent for the threeproduct lines. The one-month shift for cash flows explained 185
  • 194. PROFIT AND CASH FLOW ANALYSIS Standard Product Line Changes Cash Flows Sales revenue $1,000,000 $ 916,667 Cost of goods sold $ 650,000 $ 704,167 Gross margin $ 350,000 $ 212,500 Revenue-driven expenses @ 8.5% $ 85,000 $ 77,917 Unit-driven expenses $ 65,000 $ 59,583 Contribution margin $ 200,000 $ 75,000 Fixed operating expenses $ 0 $ 0 Profit $ 200,000 $ 75,000 Generic Product Line Changes Cash Flows Sales revenue $1,125,000 $1,031,250 Cost of goods sold $ 855,000 $ 926,250 Gross margin $ 270,000 $ 105,000 Revenue-driven expenses @ 4.0% $ 45,000 $ 41,250 Unit-driven expenses $ 75,000 $ 68,750 Contribution margin $ 150,000 ($ 5,000) Fixed operating expenses $ 0 $ 0 Profit $ 150,000 ($ 5,000) Premier Product Line Changes Cash Flows Sales revenue $ 750,000 $ 687,500 Cost of goods sold $ 400,000 $ 433,333 Gross margin $ 350,000 $ 254,167 Revenue-driven expenses @ 7.5% $ 56,250 $ 51,563 Unit-driven expenses $ 43,750 $ 40,104 Contribution margin $ 250,000 $ 162,500 Fixed operating expenses $ 0 $ 0 Profit $ 250,000 $ 162,500 FIGURE 13.2 Changes in operating cash flow from increases in sales vol- ume.186
  • 195. PROFIT GUSHES: CASH FLOW TRICKLES?Standard Product Line Changes Cash FlowsSales revenue $1,000,000 $ 916,667Cost of goods sold $ 0 $ 0Gross margin $1,000,000 $ 916,667Revenue-driven expenses @ 8.5% $ 85,000 $ 77,917Unit-driven expenses $ 0 $ 0Contribution margin $ 915,000 $ 838,750Fixed operating expenses $ 0 $ 0Profit $ 915,000 $ 838,750Generic Product Line Changes Cash FlowsSales revenue $1,125,000 $1,031,250Cost of goods sold $ 0 $ 0Gross margin $1,125,000 $1,031,250Revenue-driven expenses @ 4.0% $ 45,000 $ 41,250Unit-driven expenses $ 0 $ 0Contribution margin $1,080,000 $ 990,000Fixed operating expenses $ 0 $ 0Profit $1,080,000 $ 990,000Premier Product Line Changes Cash FlowsSales revenue $ 750,000 $ 687,500Cost of goods sold $ 0 $ 0Gross margin $ 750,000 $ 687,500Revenue-driven expenses @ 7.5% $ 56,250 $ 51,563Unit-driven expenses $ 0 $ 0Contribution margin $ 693,750 $ 635,938Fixed operating expenses $ 0 $ 0Profit $ 693,750 $ 635,938FIGURE 13.3 Changes in operating cash flow from increases in sales prices(data from Figure 10.1). 187
  • 196. PROFIT AND CASH FLOW ANALYSIS earlier for the sales volume scenario is adopted here for the sales price increase scenario. The cash flow effects are much more favorable for the sales price increase scenario than the sales volume scenario. For each of the three product lines, the increase in cash flow from profit due to the higher sales prices is a very large percent of the increase in profit. This is much better than in the sales volume increase scenario. The much more favorable cash flow effect is due to the difference in the inventories factor. In the sales price increase scenarios, the business does not have to increase inventories of products and thus avoids the drag on cash flow that this causes. A word of caution is in order. Raising sales prices 10 per-DANGER! cent looks good on paper compared with increasing sales volume 10 percent. But bumping up sales prices 10 percent in a competitive market, or in most markets for that matter, may not be possible. Customers may flock to your competi- tors, of course, or demand may decrease at the higher prices. But, having said this, businesses can often sneak in minor increases without drawing attention to the higher sales prices. Even relatively small sales price increases can improve profit more effectively than much larger increases in sales volume. And profit increases from higher sales prices have much bet- ter cash flow effects.s END POINT Improving profit performance is a relentless pressure on busi- ness managers. The preceding four chapters analyze the profit effects from changes in the key factors that drive profit—sales volume, sales price, variable operating expenses, and fixed expenses. This chapter shifts attention to changes in cash flow driven by changes in profit factors. Managers must keep in mind that profit is an accrual-basis accounting num- ber and not a cash flow number. The actual cash flow increase during the period from improving profit can be, and usually is, significantly different than the gain in profit. Indeed, the chapter demonstrates that in certain situations the cash flow effect can be negative from increasing profit. Managers need a good handle on both the profit effect and the cash flow effect from changing profit factors.188
  • 197. 4 PA R TCapitalInvestmentAnalysis
  • 198. 14 CHAPTER Determining Investment Returns NeededT This chapter explains how the cost of capital is factored into the analysis of business investments to determine the future returns needed from an investment. An investment has to pay its way. The future returns from an investment should recover the capital put into the investment and provide for the cost of capital during each period along the way. The future returns should do at least this much. If not, the investment will turn out to be a poor decision; the capital should have been invested elsewhere. The analysis in this chapter is math-free. No mathematical equations or formulas are involved. I use a computer spread- sheet model to illustrate the analysis and to do the calculations. The main example in the chapter provides a general-purpose template that can be easily copied by anyone familiar with a spreadsheet program. However, you don’t have to know any- thing about using spreadsheets to follow the analysis. A A BUSINESS AS AN ONGOINGRemember INVESTMENT PROJECT Chapter 5 explains that a business needs a portfolio of assets to carry on its profit-making operations. For the capi- tal needed to invest in its assets, a business raises money 191
  • 199. C A P I TA L I N V E S T M E N T A N A LY S I S from its owners, retains all or part of its annual earnings, and borrows money. The combination of these three sources con- stitutes the capital structure, or capitalization, of a business. Taken together, the first two capital sources are called owners’ equity, or just equity for short. Borrowed money is referred to as debt. Interest is paid on debt, as you know. Its shareowners expect a business to earn an annual return on their equity at least equal to, and preferably higher than, what they could earn on alternative investment opportunities for their capital. COST OF CAPITAL A business’s earnings before interest and income tax (EBIT) for a period needs to be sufficient to do three things: (1) pay interest on its debt, (2) pay income tax, and (3) leave residual net income that satisfies the shareowners of the busi- ness. Based on the total amount of capital invested in its assets and its capital structure, a business determines its EBIT goal for the year. For instance, a business may establish an annual EBIT goal equal to 20 percent of the total capital invested in its assets. This rate is referred to as its cost of capital. The annual cost-of-capital rate for most businesses is in the range of 15 to 25 percent, although there is no hard-and-fast standard that applies to all businesses. The cost-of-capital rate depends heavily on the target rate for net income on its own- ers’ equity adopted by a business. The interest rate on a busi- ness’s debt is definite, and its income tax rate is fairly definite. On the other hand, the rate of net income set by a business as its goal to earn on owners’ equity is not definite. A business may adopt a rather modest or a more aggressive benchmark for earnings on its equity capital. Of course, a business may fall short of its cost-of-capital DANGER! goal. Its actual EBIT for the year may be enough to pay its interest and income tax, but its residual net income may be less than the business should earn on its owners’ equity for the year. For that matter, a business may suffer an operating loss and not even cover its interest obligation for the year. One reason for reporting financial statements to outside shareown- ers and lenders is to provide them with information so they can determine how the business is performing as an investor, or user of capital.192
  • 200. DETERMINING INVESTMENT RETURNS NEEDED A company’s cost of capital depends on its capital structure.Assume the following facts for a business:Capital Structure and Cost of Capital Factors• 35 percent debt and 65 percent equity mix of capital sources• 8.0 percent annual interest rate on debt• 40 percent income tax rate (combined federal and state)• 18.0 percent annual ROE objectiveThese assumptions are realistic for a broad range of busi-nesses, but not for every business, of course. Some businessesuse less than 35 percent debt capital and some more. Overtime, interest rates fluctuate for all businesses. Furthermore,one could argue that an 18.0 percent ROE objective is tooambitious. The 40 percent combined federal and state incometax rate is based on the present rate for the federal taxableincome brackets for midsized businesses plus a typical stateincome tax rate. In any case, the cost-of-capital factors can beeasily adapted to fit the circumstances of a particular businessonce an investment spreadsheet model has been prepared. Suppose the business with this capital structure has $10million capital invested in its assets. What amount of annualearnings before interest and income tax (EBIT) should thebusiness make? This question strikes at the core idea of thecost of capital—the minimum amount of operating profitneeded to pay interest on its debt, to pay its income tax, andto produce residual net income that achieves the ROE goal ofthe business. Figure 14.1 shows the answer to this question. Given itsdebt-to-equity ratio, the company’s $10 million capital comesfrom $3.5 million debt and $6.5 million equity—see the con-densed balance sheet in Figure 14.1. The annual interest costof its debt is $280,000 ($3.5 million debt × 8.0% interest rate= $280,000 interest). The business needs to make $280,000operating profit (or earnings before interest and income tax)to pay this amount of interest.Interest is deductible for income tax, as you probably know.This means that a business needs to make operating profitequal to but no more than, its interest to pay its interest. Inother words, the $280,000 of operating profit is offset with an 193
  • 201. C A P I TA L I N V E S T M E N T A N A LY S I S Condensed Balance Sheet Condensed Income Statement Assets less Earnings before interest operating liabilities $10,000,000 and income tax (EBIT) $2,230,000 Interest ($ 280,000) Sources of Capital Taxable income $1,950,000 Debt $ 3,500,000 Income tax ($ 780,000) Equity $ 6,500,000 Net income $1,170,000 Total $10,000,000 FIGURE 14.1 Operating profit (EBIT) needed based on capital structure of the business. equal amount of interest deduction, so the business’s taxable income is zero on this layer of operating profit. Y The cost of equity capital is a much different matter. On its FL $6.5 million equity capital, the business needs to earn $1,170,000 net income ($6.5 million equity × 18.0% ROE = $1,170,000 net income). To earn $1,170,000 net income after AM income tax, the business needs to earn $1,950,000 operating earnings before income tax ($1,170,000 net income goal ÷ 0.6 = $1,950,000). The 0.6 is the after-tax keep; for every $1.00 of TE taxable income the company keeps only 60¢ because the income tax rate is 40 percent, or 40¢ on the dollar. On $1,950,000 earnings after interest and before income tax, the applicable income tax is $780,000 at the 40 percent income tax rate, which leaves $1,170,000 net income after tax. Take note of one key difference between the net income needed to be earned on equity versus the interest needed to be earned on debt. From each $1.00 of operating profit (earn- ings before interest and income tax, or EBIT) a business can pay $1.00 of interest to its debt sources of capital. But from each $1.00 of operating profit a business makes only 60¢ net income for its equity owners after deducting the 40¢ income tax on the dollar. Put another way, on a before-tax basis a business needs to earn just $1.00 of operating profit to cover $1.00 of interest expense. But it needs to earn $1.67 (rounded) to end up with $1.00 net income because income tax takes 67¢.194
  • 202. DETERMINING INVESTMENT RETURNS NEEDED In summary, based on its capital structure, the businessshould aim to earn at least $2,230,000 operating profit, orEBIT, for the year. If it falls short of this benchmark, its resid-ual net income for the year will fall below its 18.0 percentannual ROE goal. If it does better, its ROE will be more than18.0 percent, which should help increase the value of theequity shares of the business.SHORT-TERM AND LONG-TERMASSET INVESTMENTSLooking down the asset side of a business’s balance sheet, youfind a mix of short-term and long-term asset investments. Onemajor short-term asset investment is inventories. The invento-ries asset represents the cost of products held for sale. Theseproducts will be sold during the coming two or three months,perhaps even sooner. Another important short-term invest-ment is accounts receivable. Accounts receivable will be col-lected within a month or so. These two short-term investmentsturn over relatively quickly. The capital invested in inventoriesand accounts receivable is recovered in a short period of time.The capital is then reinvested in the assets in order to con-tinue in business. The cycle of capital investment, capitalrecovery, and capital reinvestment is repeated several timesduring the year. In contrast, a business makes long-term investments inmany different operating assets—land and buildings, machin-ery and equipment, furniture, fixtures, tools, computers,vehicles, and so on. A business also may make long-terminvestments in intangible assets—patents and copyrights, cus-tomer lists, computer software, established brand names andtrademarks developed by other companies, and so on. The cap-ital invested in long-term business operating assets is graduallyrecovered and converted back into cash over three to five years(or longer for buildings and heavy machinery and equipment). The annual sales revenue of a business includes a compo-nent to recover the cost of using its long-term operatingassets. (Of course, sales revenue also has to recover the cost ofthe goods sold and other operating costs to make a profit forthe period.) The cost of using long-term assets is recorded asdepreciation expense each year. Depreciation expense is not acash outlay—in fact, just the opposite. 195
  • 203. C A P I TA L I N V E S T M E N T A N A LY S I S Depreciation is one of the costs embedded in sales revenue; therefore the cash inflow from sales includes a component that reimburses the business for the use of its fixed assets during the year. A sliver of the cash inflow from the annual sales revenue of a business provides recovery of part of the total capital invested in its long-term operating assets. What to do with this cash inflow is one of the most important deci- sions facing a business. To continue as a going concern, a business has to purchase or construct new long-term operating assets to replace the old ones that have reached the end of their useful economic lives. In deciding whether to make capital investments in long-term operating assets, managers should determine whether the new assets are really needed, of course, and how they will be used in the operations of the business. They should look at how the new assets blend into the present mix of operating assets. Managers should focus primarily on how well all assets work together to achieve the financial goals of the busi- ness. These long-term capital investments of a business are just one part, though an important part to be sure, of a busi- ness’s overall profit strategy and planning. THE WHOLE BUSINESS VERSUS SINGULAR CAPITAL INVESTMENTS From the cost-of-capital viewpoint, the key criterion for guild- ing investment decisions for the replacement and expansion of long-term assets is whether the business will be able to maintain and improve its return on assets (ROA) performance. Suppose a business has been able to earn an annual 20 per- cent ROA consistently over several years. In other words, its annual EBIT divided by the total capital invested in its assets has hovered around 20 percent for the past several years. And assume that the business does not plan any significant change in its capital structure in the foreseeable future. Assume that this level of financial performance is judged to be acceptable by both management and the shareowners of the business. Therefore, in making decisions on capital expen- ditures to carry on and to grow the business, its managers should apply a 20 percent cost of capital test: Will EBIT in future years be sufficient to maintain its 20 percent ROA per-196
  • 204. DETERMINING INVESTMENT RETURNS NEEDEDformance? This is the key question from the cost-of-capitalpoint of view.ROA is an investment performance measure for the businessas a whole. The entire business is the focus of the analysis. Itsentire assemblage of assets is treated as one investment port-folio. Its earnings before interest and income tax (EBIT) forthe year is divided by this amount of capital to determine theoverall ROA performance of the business. In contrast, specific capital investments can be isolated andanalyzed as singular projects, each like a tub standing on itsown feet. Each individual asset investment opportunity is ana-lyzed on its own merits. One important criterion is whetherthe investment passes muster from the cost-of-capital point ofview.CAPITAL INVESTMENT EXAMPLESuppose that a retailer is considering buying new, state-of-the-art electronic cash registers. These registers read bar-coded information on the products it sells. The registerswould be connected with the company’s computers to trackinformation on sales and inventory stock quantities. The mainpurpose of switching to these cash registers is to avoid mark-ing sales prices on products. Virtually all the products sold bythe retailer are already bar-coded by the manufacturers of theproducts. The retailer would avoid the labor cost of markinginitial sales prices and sales price changes on its products,which takes many hours. The new cash registers would pro-vide better control over sales prices, which is another impor-tant advantage. Some of the company’s cashiers frequentlypunch in wrong prices in error; worse, some cashiers inten-tionally enter lower-than-marked prices for their friends andrelatives coming through the checkout line. Investing in the new cash registers would generate laborcost savings in the future. The company’s future annual cashoutlays for wages and fringe benefits would decrease if thenew cash registers were used. Avoiding a cash outlay is asgood as a cash inflow; both increase the cash balance. Thecost of the new cash registers—net of the trade-in allowanceon its old cash registers and including the cost of installing the 197
  • 205. C A P I TA L I N V E S T M E N T A N A LY S I S new cash registers—would be $500,000, which would be paid immediately. The company would tap its general cash reserve to invest in the new cash registers. The retailer would not use direct financing for this investment, such as asking the vendor to lend the company a large part of the purchase price. The retailer would not arrange for a third-party loan or seek a lease-purchase arrangement to acquire the cash registers. As the old expression says, the business would pay “cash on the barrelhead” for the purchase of the cash registers. The manager in charge of making the decision decides to adopt a five-year planning horizon for this capital investment. In other words, the manager limits the recognition of cost savings to five years, even though there may be benefits beyond five years. Labor-hour savings and wage rates are difficult to forecast beyond five years, and other factors can change as well. At the end of five years the cash registers are assumed to have no residual value, which is very conservative. The future labor cost savings depend mainly on how many work hours the new cash registers would save. Of course, esti- mating the annual labor cost savings is no easy matter. Instead of focusing on the precise forecasting of future labor cost savings, the manager takes a different approach. The manager asks how much annual labor cost savings would have to be to justify the investment. For example, would future labor cost savings of $160,000 per year for five years be enough? The labor cost savings would occur throughout the year. For convenience of analysis, however, assume that the cost savings occur at each year-end. The company’s cash balance would be this much higher at each year-end due to the labor cost savings. The retailer’s capital structure is that presented in the earlier example. As shown in Figure 14.1 and explained previously, the company’s before-tax annual cost of capital rate is 22.3 percent ($2,230,000 required annual EBIT ÷ $10 million total capital invested in assets = 22.3% annual cost of capital rate). However, this cost-of-capital rate cannot be simply multiplied by the $500,000 cost of the cash regis-198
  • 206. DETERMINING INVESTMENT RETURNS NEEDEDters to determine the future returns needed from the invest-ment. The cost-of-capital factors must be applied in a differentmanner. Furthermore, the future returns from the investment have to recover the $500,000 capital invested in thecash registers. After five years of use the cash registers will beat the end of their useful lives to the business and will have noresidual salvage value. In summary, the future returns have tobe sufficient to recover the cost of the cash registers and toprovide for the cost of capital each year over the life of theinvestment. Before moving on to the analysis of this capital investment,I should mention that there would be several incentives toinvest in the cash registers. As already stated, the new cashregisters would eliminate data entry errors by cashiers andwould prevent cashiers from deliberately entering low pricesfor their friends and relatives. Employee fraud is a commonand expensive problem, unfortunately. Also, the company mayanticipate that it will be increasingly difficult to hire qualifiedemployees over the next several years. Furthermore, the newcash registers would enable the company to collect marketingdata on a real-time basis, which it cannot do at present. Inshort, there are several good reasons for buying the cash reg-isters. However, the following discussion focuses on the finan-cial aspects of the investment decision.Analyzing the Investment: First CommentsThe first step is to make a ballpark estimate of how much thefuture returns would have to be for the investment. The busi-ness has to recover the capital invested in the cash registers,which is $500,000 in the example. The business has fiveyears to recover this amount of capital. But clearly, futurereturns of just $100,000 per year for five years is not enough.This amount of yearly return would not cover the company’scost of capital each year. So to start the ball rolling, an annualreturn of $160,000 is used in the analysis, which might seemto be adequate to cover the company’s cost of capital. But is$160,000 per year actually enough? 199
  • 207. C A P I TA L I N V E S T M E N T A N A LY S I S First Pass at Analyzing the Investment Figure 14.2 presents a spreadsheet analysis of the investment in the new cash registers. (In the old days before personal computers, this two-dimensional layout was called a work- sheet.) This is only a first pass to see whether $160,000 annual returns on the investment would be sufficient. The analysis may seem complex at first glance, but it is quite straightforward. The method begins with the return for each year and makes demands on the cash return. The demands are four in number: (1) interest on debt capital, (2) income tax, (3) ROE (return on equity), and (4) recovery of capital invested in the assets. The first three amounts must be calculated by fixed formulas each year. The fourth is a free-floater; these amounts can follow any pattern year to year. But their total over the five years must add to $500,000, which is the amount of capital invested in the assets. I’ll walk down the first-year column in some detail; the other four years are simply repeats of the first year. The first claim on the annual return (in this example, the labor cost savings for the year) is for interest. For year 1, the interest claim is $14,000 ($175,000 debt balance at start of year × 8.0% interest rate = $14,000 annual interest). The second demand is for income tax. The annual labor cost savings increase the company’s taxable income each year. Income tax each year depends on the interest for the year, which is deductible and on the depreciation method used for calculat- ing income tax. As shown in Figure 14.2 the straight-line depreciation method is used, which gives a $100,000 depreci- ation deduction each year for five years using a zero salvage value at the end of five years. (The accelerated depreciation method could be used instead.) The bottom layer in Figure 14.2 shows the calculation of income tax for each year attributable to the investment. The income tax for the year is entered above as the second takeout from the annual labor cost savings. The third takeout from the annual return is for earnings on equity capital (see Figure 14.2). The deduction for ROE is based on the ROE goal of 18.0 percent per year. ROE for year 1 equals $58,500 ($325,000 equity capital at start of year × 18.0% ROE = $58,500 net income).200
  • 208. DETERMINING INVESTMENT RETURNS NEEDED Interest rate 8.0% ROE 18.0% Cost-of-capital factors Income tax rate 40.0% Debt % of capital 35.0% Equity % of capital 65.0% Year 1 Year 2 Year 3 Year 4 Year 5Annual ReturnsLabor cost savings $160,000 $160,000 $160,000 $160,000 $160,000Distribution of ReturnsFor interest ($ 14,000) ($ 12,065) ($ 9,872) ($ 7,384) ($ 4,564)For income tax ($ 18,400) ($ 19,174) ($ 20,051) ($ 21,046) ($ 22,174)For ROE ($ 58,500) ($ 50,415) ($ 41,249) ($ 30,856) ($ 19,072)Equals capital recovery $ 69,100 $ 78,346 $ 88,828 $100,713 $114,189Cumulative capital recovery at end of year $ 69,100 $147,446 $236,274 $336,987 $451,176Capital Invested at Beginning of YearDebt $175,000 $150,815 $123,394 $ 92,304 $ 57,054Equity $325,000 $280,085 $229,160 $171,422 $105,958Total $500,000 $430,900 $352,554 $263,726 $163,013Income TaxEBIT increase $160,000 $160,000 $160,000 $160,000 $160,000Interest expense ($ 14,000) ($12,065) ($ 9,872) ($ 7,384) ($ 4,564)Depreciation ($100,000) ($100,000) ($100,000) ($100,000) ($100,000)Taxable income $ 46,000 $ 47,935 $ 50,128 $ 52,616 $ 55,436Income tax $ 18,400 $ 19,174 $ 20,051 $ 21,046 $ 22,174FIGURE 14.2 Analysis of investment in cash registers, assuming $160,000annual returns. 201
  • 209. C A P I TA L I N V E S T M E N T A N A LY S I S As mentioned, the $160,000 annual cash returns amount used in Figure 14.2 is just the starting point in the analysis. This amount may not be enough to actually achieve the 18.0 percent annual ROE goal of the business. The purpose of the analysis is to test whether the $160,000 annual returns would be enough to achieve the ROE goal of the business. Of course, if the ROE goal of the business had been lower than 18.0 per- cent, then the deduction for ROE from the annual return would be a smaller amount. The fourth and final demand on each year’s cash return is for capital recovery. Capital recovery is the residual amount remaining after deducting interest, income tax, and the ROE amount for the year. For year 1, capital recovery is $69,100 (see Figure 14.2). This is the residual amount remain- ing from the annual return after deducting the requirements for interest, income tax, and ROE. The amount of capital recovery is not reinvested in additional cash registers; the company has all the cash registers it needs, at least for the time being. In the future, the business may consider replacing the cash registers or increasing the number of cash regis- ters it uses. But as far as this particular investment is con- cerned the capital recovery each year simply goes back to the cash balance of the business. The capital leaves this project (the cash registers investment). The business may put the money in another investment, or may increase its cash balance, or may reduce its debt, or may pay a higher cash dividend. As shown in Figure 14.2, in the first year the company liquidates $69,100 of its investment in the cash registers; this much of the total capital that was originally invested in the assets is recovered and is no longer tied up in this particular investment. Therefore the amount of capital invested during the second year is reduced by $69,100 ($500,000 initial capital − $69,100 capital recovery = $430,900 capital invested at start of year 2). Debt supplies 35 percent of this capital balance and equity the other 65 percent, as shown in the column for year 2. From year to year this investment sizes down, because each year the business recovers part of the original capital invested in the assets. Thus the annual amounts of interest and ROE202
  • 210. DETERMINING INVESTMENT RETURNS NEEDEDearnings decrease year to year as the total capital investeddecreases from year to year. But note that the income taxincreases year to year because the annual interest expensededuction decreases. The cumulative capital recovery at the end of each year isshown in Figure 14.2. At the end of the fifth and final year ofthe investment, this amount should equal the initial amount ofcapital invested in the assets, which is $500,000 in this exam-ple. As Figure 14.2 shows, the cumulative capital recoveryfalls short of $500,000, however.Why a Second Pass at the Investment Is NeededGiven the annual returns of $160,000 the cumulative capitalrecovery at the end of the investment is only $451,176 (seeFigure 14.2). But the business has to recover $500,000 capitalfrom the investment, which is the initial amount of capitalinvested in the cash registers. Thus the annual returns of$160,000 are not enough. The $160,000 amount of annualreturns does not generate enough capital recovery after takingout interest, income tax, and earnings on equity each year—unless the ROE for each year is lowered so that more wouldbe available for capital recovery each year.Suppose the business goes ahead with the investment and itturns out that the annual returns are only $160,000 per year.In this situation the actual ROE rate earned on the investmentwould be lower than the 18.0 percent used in Figure 14.2.The precise ROE rate, assuming that the annual returns are$160,000, can be solved with the spreadsheet model. Insteadof using the preestablished 18.0 percent rate, the ROE rate islowered until the exact rate is found that makes the total capi-tal recovery over the five years equal to $500,000. The appen-dix at the end of this chapter (Figure 14.5) shows the solutionfor the exact ROE rate, which is 14.6613 percent. At the $160,000 level of annual returns the cash registersinvestment is not completely attractive, assuming that thebusiness is serious about earning the annual 18.0 percentROE rate. Clearly, the annual returns have to be higher than$160,000. The manager should ask his or her accountant orother financial staff person to determine the amount of annuallabor cost savings that would justify the investment from thecost-of-capital viewpoint. 203
  • 211. C A P I TA L I N V E S T M E N T A N A LY S I S Determining Exact Amounts for Returns The investment analysis model shown in Figure 14.2 for the cash registers example is the printout of my personal com- puter spreadsheet program. One reason for using a spread- sheet for capital investment analysis to is do all the required calculations quickly and accurately. Another reason is that the factors in the analysis can be easily changed for the purpose of investigating different scenarios for the investment. I changed the annual cash returns in order to find the exact amount required to earn an annual 18.0 percent ROE. Other input variables were held the same; only the amount of the annual labor cost savings was changed. With a change in the amount of annual returns, the output variables for each year change accordingly—in particular, the income tax for each year and the amount of capital invested each year, which in turn change the amounts of interest and earnings on equity for each year. There is a cascade effect on the output variables Y from changing the amount of annual returns. FL Finding the precise answer requires a trial-and-error, or plug-and-chug process that is repeated until the exact amount AM of future annual cash returns is found that makes total capital recovery $500,000. This may seem to be time-consuming, but it’s not. Only a few trials or passes are required to zero in on the exact answer. From Figure 14.2 I already knew that TE $160,000 was too low. So I bumped up the annual returns fig- ure to $175,000. This proved to be a little too high. After a few trials I converged on the exact amount. Figure 14.3 pre- sents the answer. Annual labor cost savings of $172,463 for five years yield an annual 18.0 percent ROE and recover exactly $500,000 capital from the investment. Now comes the hard part. The manager must decide whether the business could, realistically, achieve $172,463 annual labor cost savings. This is the really tough part of the decision-making process. But the manager knows that if the annual labor cost savings turn out to be this amount or higher, then the investment will prove to be a good decision from the cost-of-capital point of view. Note in Figure 14.3 that the annual depreciation tax deduction amounts differ from the annual capital recovery amounts. For instance, the first year’s depreciation tax deduction is204
  • 212. DETERMINING INVESTMENT RETURNS NEEDED Interest rate 8.0% ROE 18.0% Cost-of-capital factors Income tax rate 40.0% Debt % of capital 35.0% Equity % of capital 65.0% Year 1 Year 2 Year 3 Year 4 Year 5Annual ReturnsLabor cost savings $172,463 $172,463 $172,463 $172,463 $172,463Distribution of ReturnsFor interest ($ 14,000) ($ 11,856) ($ 9,425) ($ 6,668) ($ 3,543)For income tax ($ 23,385) ($ 24,243) ($ 25,215) ($ 26,318) ($ 27,568)For ROE ($ 58,500) ($ 49,540) ($ 39,382) ($ 27,865) ($ 14,806)Equals capital recovery $ 76,578 $ 86,824 $ 98,441 $111,612 $126,546Cumulative capital recovery at end of year $ 76,578 $163,401 $261,842 $373,454 $500,000Capital Invested at Beginning of YearDebt $175,000 $148,198 $117,810 $ 83,355 $ 44,291Equity $325,000 $275,225 $218,789 $154,803 $ 82,255Total $500,000 $423,422 $336,599 $238,158 $126,546Income TaxEBIT increase $172,463 $172,463 $172,463 $172,463 $172,463Interest expense ($ 14,000) ($ 11,856) ($ 9,425) ($ 6,668) ($ 3,543)Depreciation ($100,000) ($100,000) ($100,000) ($100,000) ($100,000)Taxable income $ 58,463 $ 60,607 $ 63,038 $ 65,794 $ 68,919Income tax $ 23,385 $ 24,243 $ 25,215 $ 26,318 $ 27,568FIGURE 14.3 Exact amount of future returns required for investment. $100,000 (using the straight-line method) but the capital recovery for the first year is $76,578. Both the total deprecia- tion over the five years and the total capital recovery over the five years are $500,000. But the two amounts differ from year to year. This disparity is typical of capital investments and 205
  • 213. C A P I TA L I N V E S T M E N T A N A LY S I S does not present a problem when using a spreadsheet model for analysis. (The difference between these two factors is much more of a nuisance in using the mathematical analysis techniques discussed in the Chapter 15.) FLEXIBILITY OF A SPREADSHEET MODEL As mentioned before, any factor in the analysis can be changed to test how sensitive the annual returns would be to the change. For instance, instead of the straight-line method the accelerated depreciation method could be used in calculat- ing income tax. Instead of uniform labor cost savings across the years, returns could be set lower in the early years and higher in the later years—or vice versa. The debt-to-equity ratio can be shifted. Of course, the interest rate and ROE tar- get rate can be changed. Once a change is entered, the effects of the change are instantly available on screen. To illustrate an alternative scenario for the cash registers example, assume the following cost of capital situation for the retailer instead of the preceding example: Capital Structure and Cost of Capital Factors • No debt; 100 percent equity source of capital • Annual interest rate on debt—not applicable • 40 percent income tax rate • 18.0 percent annual ROE objective In this alternative scenario, the business uses no debt capital; all its capital comes from equity sources (capital invested by its shareowners and retained earnings). The ROE target rate is the same as before (18 percent annual ROE). Figure 14.4 shows the annual returns that would be needed in this situa- tion. The required annual returns would jump to $199,815 compared with $172,463 in the earlier example, an increase of more than $27,000 per year! This is a rather significant increase. The capital structure of the business makes a differ- ence on the future returns needed from an investment. LEASING VERSUS BUYING LONG-TERM ASSETS Business managers have opportunities for leasing instead of buying long-term operating assets. Most long-term operating206
  • 214. DETERMINING INVESTMENT RETURNS NEEDED Interest rate 0.0% ROE 18.0% Cost-of-capital factors Income tax rate 40.0% Debt % of capital 0.0% Equity % of capital 100.0% Year 1 Year 2 Year 3 Year 4 Year 5Annual ReturnsLabor cost savings $199,815 $199,815 $199,815 $199,815 $199,815Distribution of ReturnsFor interest $ 0 $ 0 $ 0 $ 0 $ 0For income tax ($ 39,926) ($ 39,926) ($ 39,926) ($ 39,926) ($ 39,926)For ROE ($ 90,000) ($ 77,420) ($ 62,576) ($ 45,059) ($ 24,390)Equals capital recovery $ 69,889 $ 82,469 $ 97,313 $114,830 $135,499Cumulative capital recovery at end of year $ 69,889 $152,358 $249,671 $364,501 $500,000Capital Invested at Beginning of YearDebt $ 0 $ 0 $ 0 $ 0 $ 0Equity $500,000 $430,111 $347,642 $250,329 $135,499Total $500,000 $430,111 $347,642 $250,329 $135,499Income TaxEBIT increase $199,815 $199,815 $199,815 $199,815 $199,815Interest expense $ 0 $ 0 $ 0 $ 0 $ 0Depreciation ($100,000) ($100,000) ($100,000) ($100,000 ($100,000)Taxable income $ 99,815 $ 99,815 $ 99,815 $ 99,815 $ 99,815Income tax $ 39,926 $ 39,926 $ 39,926 $ 39,926 $ 39,926FIGURE 14.4 Future returns required from investment for an alternativescenario (all equity, no debt). 207
  • 215. C A P I TA L I N V E S T M E N T A N A LY S I S assets (trucks, equipment, machinery, computers, telephone systems, etc.) can be leased, either directly from the manufac- turer of the asset or indirectly through a third-party leasing specialist. The cash registers probably could be leased instead of purchased. Leasing may be very appealing if the business is short of cash. Perhaps the lessor has a lower cost of capital than the busi- ness, in which case the business might be better off leasing rather than investing its own capital in the assets. Then again, the lessor’s cost of capital may be higher, which means that the lease rents would be higher than the returns needed by the business based on its lower cost-of-capital rate. Compli- cating matters is the fact that the term of the lease and pat- tern of lease rents may differ from the stream of returns generated from the assets. Also, leases typically offer a purchase option at the end of the lease, at which time the business can purchase the assets. And leases are very complicated legal contracts that generally impose all kinds of conditions and constraints on the lessee. Many leases involve front-end cash outlays by the lessee. In short, comparing the purchase of long-term assets against leasing the same assets can be very difficult—like comparing apples and oranges. But to illustrate certain basic points regarding the lease- versus-buy decision, suppose the retailer had the opportu- nity to lease the cash registers instead of buying them. Suppose the lessor quotes monthly rents of $14,372 for five years, which equals a total annual rent of $172,463. I selected this rent amount to equal the amount of the annual labor cost savings for the business to earn 18.0 percent ROE (see Figure 14.3). Also assume that the business would have the option to purchase the cash registers for a nominal amount at the end of the five-year lease. Thus the business would end up in the same position as if it had purchased the assets to begin with. Generally, the lessee (the retailer) bears all costs of posses- sion and use of the assets as if it had bought them outright. For example, the retailer would pay the fire and theft insur- ance on the assets whether they are owned or leased. By leas- ing the cash registers, the retailer would reduce its annual208
  • 216. DETERMINING INVESTMENT RETURNS NEEDEDlabor costs by $172,463, but would pay annual lease rents ofthe same amount. From the financial point of view, leasingversus buying is a standoff in this case. The retailer may nothave any other investment opportunities that would generatean annual 18.0 percent ROE. So if it has the money, theretailer may prefer to make the investment instead of leasingthe cash registers, thus employing its capital and earning anannual 18.0 percent ROE on the investment. Leases involve certain considerations beyond just thefinancial aspects. For one thing, the retailer may prefer not toassume the economic risks of owning the cash registers. In afast-changing technological environment, a business may bereluctant to assume the risks making long-term investmentsin assets that may become obsolete in two or three years. Soa business may shop around for a two- or three-year lease. The simplest analysis situation for comparing leasing withbuying assets is this. Suppose a business has identified apromising opportunity for which it needs to acquire certainassets that would generate a stream of future returns for somany years, say $150,000 per year for seven years. (Thisforecast of future returns may turn out to be too optimistic, ofcourse.) Assume that the business is short of cash and that ithas tapped out its capital sources. It would be difficult for thebusiness to raise additional capital. Assume that a leasingspecialist is willing to rent the assets to the business for$10,000 per month, or $120,000 per year for five years. Atthe end of the lease the business would have the option topurchase the assets for a nominal amount. In this scenario the lease makes sense, keeping in mind therisk that the future returns may turn out to be lower than$150,000 per year. The business would realize a $30,000 gainin its operating profit each year ($150,000 annual returnsfrom using the assets − $120,000 annual lease rents =$30,000 net gain). This is the simplest way to analyze leases.In actual situations the analysis is much more complicated. Inany case, a business should determine the stream of futurereturns from acquiring the assets. If the assets are purchased,the returns provide the money to recover the capital investedin the assets and cover the business’s cost of capital along theway. If the assets are leased, the returns provide the money topay the lease rents. 209
  • 217. C A P I TA L I N V E S T M E N T A N A LY S I S A WORD ON CAPITAL BUDGETING In theory, a business should assemble all its possible investment opportunities, compare them, and rank-order them. The busi- ness should select the one with the highest ROE first, and so on. In allocating scarce capital among competing investment oppor- tunities, ROE is the key criterion. According to this view of the world, the job of the business manager is to ration a limited amount of capital among competing investment alternatives. The premise of rationing scarce capital resources is why the general topic of capital investment analysis is sometimes called capital budgeting. The term budgeting here is used in the allocation or apportionment sense, not in the sense of overall business management planning and goal setting. The comparative analysis of competing investment alternatives is beyond the scope of this book. Corporate financial manage- ment books cover this topic in depth.s END POINT Business managers make many long-term capital investment decisions. The analysis of capital investments hinges on the cost-of-capital requirements of the business, which depend on the company’s mix of debt and equity capital, the cost of each, and the income tax situation of the business. The cost of equity capital is not a contractual rate like interest. Management decides on the ROE (return on equity) objective for the business. Based on the amount of capital invested, a manager can determine the amounts of future returns that will be needed to satisfy the cost-of-capital requirements of the business. The manager has to judge whether these future returns can actu- ally be achieved. The chapter explains how to apply the cost- of-capital imperatives of a business in making capital investment decisions. A spreadsheet model is used to analyze and illustrate a prototype capital investment. A spreadsheet model has two important advantages: It is an excellent device for organizing and presenting the relevant information for an investment, and it is a versatile tool for examining different scenarios of an investment. Analysis is important, to be sure. But we should not get carried away. More important is the ability of managers to find good capital investment opportunities and blend them into the overall strategic plan of the business.210
  • 218. DETERMINING INVESTMENT RETURNS NEEDED CHAPTER APPENDIX Interest rate 8.0% ROE 14.6613% Exact ROE rate solved for in this figure Income tax rate 40.0% Debt % of capital 35.0% Equity % of capital 65.0% Year 1 Year 2 Year 3 Year 4 Year 5Annual ReturnsLabor cost savings $160,000 $160,000 $160,000 $160,000 $160,000Distribution of ReturnsFor interest ($ 14,000) ($ 11,761) ($ 9,272) ($ 6,503) ($ 3,424)For income tax ($ 18,400) ($ 19,295) ($ 20,291) ($ 21,399) ($ 22,630)For ROE ($ 47,649) ($ 40,030) ($ 31,557) ($ 22,134) ($ 11,654)Equals capital recovery $ 79,951 $ 88,913 $ 98,880 $109,964 $122,291Cumulative capital recovery at end of year $ 79,951 $168,864 $267,744 $377,709 $500,000Capital Invested at Beginning of YearDebt $175,000 $147,017 $115,898 $ 81,290 $ 42,802Equity $325,000 $273,032 $215,238 $150,966 $ 79,489Total $500,000 $420,049 $331,136 $232,256 $122,291Income TaxEBIT increase $160,000 $160,000 $160,000 $160,000 $160,000Interest expense ($ 14,000) ($ 11,761) ($ 9,272) ($ 6,503) ($ 3,424)Depreciation ($100,000) ($100,000) ($100,000) ($100,000 ($100,000)Taxable income $ 46,000 $ 48,239 $ 50,728 $ 53,497 $ 56,576Income tax $ 18,400 $ 19,295 $ 20,291 $ 21,399 $ 22,630FIGURE 14.5 Exact ROE rate for cash registers capital investment with$160,000 annual returns. 211
  • 219. 15 CHAPTERDiscountingInvestment ReturnsExpectedTThis chapter and Chapter 14 are like a set of bookends. Chap-ter 14 explains the analysis of long-term investments in oper-ating assets by businesses. This chapter continues the topic,with one key difference. The time line of analysis in the previous chapter goes likethis:Present FutureStarting with a given amount of capital invested today, theanalysis looks forward in time to determine the amounts offuture returns that would be needed in order to satisfy thecost-of-capital requirements of the business. The time line of analysis in this chapter goes like this:Present FutureStarting with the amounts of future returns from an invest-ment (which are treated as fixed) the analysis travels back-ward in time to determine an amount called the present valueof the investment. The present value is the most that a busi-ness should be willing to invest today to receive the futurereturns from the investment, based on its cost-of-capitalrequirements. The present value is compared with the entrycost of an investment. 213
  • 220. C A P I TA L I N V E S T M E N T A N A LY S I S TIME VALUE OF MONEY AND COST OF CAPITAL The pivotal idea in this and the previous chapter is the time value of money. This term refers not only to money but also more broadly to capital and economic wealth in general. Capi- tal should generate income, gain, or profit over the time it is used. The ratio of earnings on the capital invested over a period of time, one year being the standard time period of ref- erence, is the measure for the time value of money. Karl Marx said that capital is “dead labor” and argued that capital should be publicly owned for the good of everyone. I won’t pursue this economic philosophy any further. Quite clearly, in our economic system capital does have a time value—or a time cost depending on whose shoes you’re standing in. The business example in Chapter 14 has the following capi- tal structure and cost-of-capital factors: Y Capital Structure and Cost-of-Capital Factors FL • 35 percent debt and 65 percent equity mix of capital sources • 8.0 percent annual interest rate on debt AM • 40 percent income tax rate (combined federal and state) • 18.0 percent annual ROE objective The same business example is continued this chapter. The TE debt and equity mix and the cost-of-capital factors differ from business to business, of course. But for a large swath of busi- nesses this scenario is in the middle of the fairway. Chapter 14 focuses on a decision of a retailer regarding investing in cash registers that would generate labor cost sav- ings in the future. The analysis reveals that $160,000 annual returns from the cash registers investment wouldn’t be enough to justify the investment; the annual returns would have to be $172,463. Figures 14.2 and 14.3 illustrate these important points. Assuming that annual returns of $172,463 could be earned for five years by using the cash registers, the present value of the investment would be exactly $500,000. The entry cost of the investment is $500,000; this is the initial amount of capital that would be invested in the cash registers. When the present value exactly equals the entry cost of an investment, the future returns are the exact amounts needed to recover the total capital invested in the214
  • 221. DISCOUNTING INVESTMENT RETURNS EXPECTEDassets and to satisfy the business’s cost-of-capital require-ments each year during the life of the investment. The presentvalue of an investment is found by discounting its futurereturns.BACK TO THE FUTURE: DISCOUNTINGINVESTMENT RETURNSThe first pass in analyzing the cash registers investment bythe retailer in Chapter 14 is a scenario in which the futureannual returns would be $160,000 for five years. Relative tothe business’s cost-of-capital requirements, this stream offuture returns would be too low. The business would notrecover the full $500,000 amount of capital that would beinvested in the cash registers. Looking at it another way, if thebusiness invested $500,000 and realized only $160,000 laborcost savings for five years, the annual return on equity (ROE)for this investment would fall short of its 18.0 percent goal. Suppose the seller of the cash registers is willing to dickeron the price. The $500,000 asking price for the cash registersis not carved in stone; the seller will haggle over the price. Atwhat price would the cash registers investment be acceptablerelative to the company’s cost-of-capital requirements? Usingthe spreadsheet model explained in Chapter 14, I lowered thepurchase price so that the total capital recovered over the lifeof the investment equals the purchase price. I kept the cost-of-capital factors the same, and I kept the future annual returnsat $160,000. Finding the correct purchase price required onlya few iterations using the spreadsheet model. Figure 15.1 presents the solution to the question. Supposethe retailer could negotiate a purchase price of $463,868. Atthis price the investment makes sense from the cost-of-capitalpoint of view. The total capital recovered over the five years isexactly equal to this purchase price. By the way, note that theannual depreciation amounts for income tax purposes arebased on this lower purchase cost.One important advantage of using a spreadsheet model forcapital investment analysis is that any of the variables for theinvestment can be changed to explore a variety of questionsand to examine a diversity of scenarios. The scenario pre-sented in Figure 15.1 is, “What if the purchase price wereonly $463,868?” 215
  • 222. C A P I TA L I N V E S T M E N T A N A LY S I S Interest rate 8.0% ROE 18.0% Cost-of-capital factors Income tax rate 40.0% Debt % of capital 35.0% Equity % of capital 65.0% Year 1 Year 2 Year 3 Year 4 Year 5 Annual Returns Labor cost savings $160,000 $160,000 $160,000 $160,000 $160,000 Distribution of Returns For interest ($12,988) ($10,999) ($8,744) ($6,187) ($3,287) For income tax ($21,695) ($22,491) ($23,393) ($24,416) ($25,576) For ROE ($54,273) ($45,960) ($36,536) ($25,851) ($13,736) Equals capital recovery $71,044 $80,550 $91,327 $103,547 $117,401 Cumulative capital recovery at end of year $71,044 $151,593 $242,921 $346,467 $463,868 Capital Invested at Beginning of Year Variable solved for in this analysis Debt $162,354 $137,488 $109,296 $77,332 $41,090 Equity $301,514 $255,336 $202,978 $143,616 $76,310 Total $463,868 $392,824 $312,275 $220,947 $117,401 Income Tax EBIT increase $160,000 $160,000 $160,000 $160,000 $160,000 Interest expense ($12,988) ($10,999) ($8,744) ($6,187) ($3,287) Depreciation ($92,774) ($92,774) ($92,774) ($92,774) ($92,774) Taxable income $54,238 $56,227 $58,483 $61,040 $63,939 Income tax $21,695 $22,491 $23,393 $24,416 $25,576 FIGURE 15.1 Purchase cost of cash registers that would justify the invest- ment relative to the business’s cost-of-capital requirements.216
  • 223. DISCOUNTING INVESTMENT RETURNS EXPECTED Solving for the present value is called discounting thefuture returns. This analysis technique is also called the dis-counted cash flow (DCF) method and usually is explained in amathematical context using equations applied to the futurestream of returns.SPREADSHEETS VERSUS EQUATIONSThe DCF method is very popular. However, I favor a spread-sheet model to determine the present value of an investment.Spreadsheet programs are very versatile. Furthermore, aspreadsheet does all the irksome calculations involved ininvestment analysis. Different scenarios can be examinedquickly and efficiently, which I find to be an enormous advan-tage. In business capital investment situations, managers haveto make several critical assumptions and forecasts. The man-ager is well advised to test the sensitivity of each critical inputfactor. A spreadsheet model is an excellent device for doingthis.Even if you are not a regular spreadsheet user, the logic andlayout of the spreadsheet presented in Figure 15.1 are impor-tant to understand. Figure 15.1 provides the relevant informa-tion for the management decision-making phase and formanagement follow-through after a decision is made. Theyear-by-year data points shown in Figure 15.1 are goodbenchmarks for monitoring and controlling the actual resultsof the investment as it plays out each year. In short, a spread-sheet model is a very useful analysis tool and is a good wayfor organizing the relevant information about an investment. Frankly, another reason for using a spreadsheet model is toavoid mathematical methods for analyzing capital invest-ments. In Chapter 14 not one equation is presented, and sofar in this chapter not one equation is presented. In my expe-rience, managers are put off by a heavy-handed mathematicalapproach loaded with arcane equations and unfamiliar sym-bols. However, in the not-so-distant past, personal computerswere not as ubiquitous as they are today, and spreadsheetprograms were not nearly so sophisticated. In the old days (before personal computers came along),certain mathematical techniques were developed to do capitalinvestment analysis computations. These techniques have 217
  • 224. C A P I TA L I N V E S T M E N T A N A LY S I S become entrenched in the field of capital investment analysis. Indeed, the techniques and terminology are household words that are used freely in the world of business and finance— such as present value, discounted cash flow, and internal rate of return. Business managers should have at least a nodding acquaintance with these terms and a general idea of how the techniques are applied. The remainder of this chapter presents a quick, introduc- tory tour of the mathematical techniques for capital invest- ment analysis. To the extent possible, I avoid going into detailed explanations of the computational equations, which I believe have little interest to business managers. These quantitative techniques are just different ways of skinning the cat. I think a spreadsheet model is a better tool of analysis, which reminds me of a personal incident several years ago. I was shopping for a mortgage on the new house we had just bought. One loan officer pulled out a well-worn table of columns and rows for different interest rates and different loan amount modules. He took a few minutes to determine the monthly payment amount for my mortgage loan. I had brought a business/financial calculator to the meeting. I double-checked his answer and found that it was incorrect. He was somewhat offended and replied that he had been doing these sorts of calculations for many years, and per- haps I had made a mistake. It took me only five seconds to check my calculation. I was right. He took several minutes to compute the amount again and was shocked to discover that his first amount was wrong. I thought better of suggest- ing that he should use a calculator to do these sorts of calcu- lations. DISCOUNTED CASH FLOW (DCF) To keep matters focused on bare-bones essentials, suppose that a business has no debt (and thus no interest to pay) and is organized as a pass-through entity for income tax purposes. The business does not pay income tax as a separate entity. Its only cost-of-capital factor is its annual return on equity (ROE) goal. Assume that the business has established an annual 15 percent ROE goal. (Of course, the ROE could be set lower or higher than 15 percent.) Assume that the business has an218
  • 225. DISCOUNTING INVESTMENT RETURNS EXPECTEDinvestment opportunity that promises annual returns at theend of each year as follows: At End of Year Returns 1 $115,000.00 2 $132,250.00 3 $152,087.50What is the value of this investment to the business today, atthe present time? This is called the present value (PV) of theinvestment. The discounted cash flow (DCF) method of analysis com-putes the present value as follows:Present Value CalculationsYear 1 $115,000.00 ÷ (1 + 15%)1 = $100,000Year 2 $132,250.00 ÷ (1 + 15%)2 = $100,000Year 3 $152,087.50 ÷ (1 + 15%)3 = $100,000Present value = $300,000 I rigged the future return amounts for each year so that thecalculations are easier to follow. Of course, a business shouldforecast the actual future returns for an investment. The futurereturns represent either increases of cash inflows from mak-ing the investment or decreases of cash outflows (as in thecash registers investment example). Each future return is dis-counted, or divided by a number greater than 1. Thus, theterm discounted cash flow. The divisor in the DCF calculations equals (1 + r)n, in which r is the cost-of-capital rate each period and nis the number of periods until the future return is realized.Usually r is constant from period to period over the life of theinvestment, although a different cost-of-capital rate could beused for each period. In summary, the present value of this investment equals$300,000. This means that if the business went ahead and put$300,000 capital into the investment and at the end of eachyear realized a future return according to the preceding 219
  • 226. C A P I TA L I N V E S T M E N T A N A LY S I S schedule, then the business would earn exactly 15 percent annual ROE on the investment. To check this present value, I used my spreadsheet model. Figure 15.2 shows the printout of the spreadsheet model, as adapted to the circumstances of this investment. At the end of the third year the full $300,000 capital invested is recovered, which proves that the present value of the investment equals $300,000, using the 15 percent cost-of-capital discount rate. The DCF method can be used when the future returns from an investment are known or can be predicted fairly accurately. The purpose is to determine the present value (PV) of an investment, which is the maximum amount that a business should invest today in exchange for the future Interest rate 0.0% ROE 15.0% Cost-of-capital factors Income tax rate 0.0% Debt % of capital 0.0% Equity % of capital 100.0% Year 1 Year 2 Year 3 Annual Returns Labor cost savings $115,000.00 $132,250.00 $152,087.50 Distribution of Returns For interest $ 0.00 $ 0.00 $ 0.00 For income tax $ 0.00 $ 0.00 $ 0.00 For ROE ($ 45,000.00) ($ 34,500.00) ($ 19,837.50) Equals capital recovery $ 70,000.00 $ 97,750.00 $132,250.00 Cumulative capital recovery at end of year $ 70,000.00 $167,750.00 $300,000.00 Capital Invested at Beginning of Year Debt $ 0.00 $ 0.00 $ 0.00 Equity $300,000.00 $230,000.00 $132,250.00 Total $300,000.00 $230,000.00 $132,250.00 FIGURE 15.2 Check on the present value calculated by the DCF method.220
  • 227. DISCOUNTING INVESTMENT RETURNS EXPECTEDreturns. The DCF technique is correct, of course. But it hasone problem. Well, actually two problems—one not so seriousand one more serious. The not-so-serious problem concerns how to do the com-putations required by the DCF method. One way is to use ahandheld business/financial calculator. These are very power-ful, relatively cheap, and fairly straightforward to use (assum-ing you read the owner’s manual). Another way is to use thefinancial functions included in a spreadsheet program.(Excel® includes a complete set of financial functions.)The second problem in using the DCF method is more sub-stantive and has nothing to do with the computations forpresent value. The problem concerns the lack of informationin using the DCF technique. The unfolding of the investmentover the years is not clear from the present value (PV) calcula-tion. Rather than opening up the investment for closer inspec-tion, the PV computation closes it down and telescopes theinformation into just one number. The method doesn’t revealimportant information about the investment over its life. Figure 15.2 presents a more complete look at the invest-ment. It shows that the cash return at the end of year one issplit between $45,000 earnings on equity and $70,000 capitalrecovery. The capital recovery aspect of an investment is veryimportant to understand. The capital recovery portion of thecash return at the end of the first year reduces the amount ofcapital invested during the second year. Only $230,000 isinvested during the second year ($300,000 initial amountinvested − $70,000 capital recovered at end of year one =$230,000 capital invested at start of year 2). Business invest-ments are self-liquidating over the life of the investment; thereis capital recovery each period, as in this example.Managers should anticipate what to do with the $70,000 capi-tal recovery at the end of the first year. (For that matter, man-agers should also plan what to do with the $45,000 netincome.) Will the capital be reinvested? Will the business beable to reinvest the $70,000 and earn 15 percent ROE? Toplan ahead for the capital recovery from the investment, man-agers need information as presented in Figure 15.2, whichtracks the earnings and capital recovery year by year. TheDCF technique does not generate this information. 221
  • 228. C A P I TA L I N V E S T M E N T A N A LY S I S NET PRESENT VALUE AND INTERNAL RATE OF RETURN (IRR) Suppose the business has an investment opportunity that would cost $300,000 to enter today. (Recall that in this exam- ple the business has no debt and is a pass-through tax entity that does not pay income tax.) The manager forecasts the future returns from the investment would be as follows: At End of Year Returns 1 $118,000.00 2 $139,240.00 3 $164,303.20 The present value and the net present value for this stream of future returns is calculated as follows: Present Value Calculations Year 1 $118,000.00 ÷ (1 + 15%)1 = $102,608.70 Year 2 $139,240.00 ÷ (1 + 15%)2 = $105,285.44 Year 3 $164,303.20 ÷ (1 + 15%)3 = $108,032.02 Present value = $315,926.16 Entry cost of investment ($300,000.00) Net present value = $15,926.16 The present value is $15,926.16 more of the amount of capital that would have to be invested. The difference between the calculated present value (PV) and the entry cost of an invest- ment is called its net present value (NPV). Net present value is negative when the PV is less than the entry cost of the invest- ment. The NPV has informational value, but it’s not an ideal measure for comparing alternative investment opportunities. For this purpose, the internal rate of return (IRR) for each investment is determined and the internal rates of return for all the investments are compared. The IRR is the precise discount rate that makes PV exactly equal to the entry cost of the investment. In the example, the investment has a $300,000 entry cost. The222
  • 229. DISCOUNTING INVESTMENT RETURNS EXPECTEDIRR for the stream of future returns from the investment is18.0 percent, which is higher than the 15.0 percent cost-of-capital discount rate used to compute the PV. The IRR rate iscalculated by using a business/financial calculator or by enter-ing the relevant data in a spreadsheet program using the IRRfinancial function. Figure 15.3 demonstrates that the IRR for the investment is18.0 percent. This return-on-capital rate is used to calculatethe earnings on capital invested each year that is deductedfrom the return for that year. The remainder is the capitalrecovery for the year. The total capital recovered by the end ofthe third year equals the $300,000 entry cost of the invest-ment (see Figure 15.3). Thus the internal rate of return (IRR)is 18.0 percent. Interest rate 0.0% Internal rate of return (IRR) ROE 18.0% Income tax rate 0.0% Debt % of capital 0.0% Equity % of capital 100.0% Year 1 Year 2 Year 3 Annual ReturnsLabor cost savings $118,000.00 $139,240.00 $164,303.20 Distribution of ReturnsFor interest $ 0.00 $ 0.00 $ 0.00For income tax $ 0.00 $ 0.00 $ 0.00For ROE ($ 54,000.00) ($ 42,480.00) ($ 25,063.20)Equals capital recovery $ 64,000.00 $ 96,760.00 $139,240.00Cumulative capital recovery at end of year $ 64,000.00 $160,760.00 $300,000.00 Capital Invested at Beginning of YearDebt $ 0.00 $ 0.00 $ 0.00Equity $300,000.00 $236,000.00 $139,240.00Total $300,000.00 $236,000.00 $139,240.00FIGURE 15.3 Illustration that internal rate of return (IRR) is 18.0 percent. 223
  • 230. C A P I TA L I N V E S T M E N T A N A LY S I S A business should favor investments with higher IRRs in preference to investments with lower IRRs—all other things being the same. A business should not accept an investment that has an IRR less than its hurdle rate, that is, its cost-of- capital rate. Another way of saying this is that a business should not proceed with an investment that has a negative net present value. Well, this is the theory. Capital investment decisions are complex and often involve many nonquantitative, or qualitative, factors that are difficult to capture fully in the analysis. A company may go ahead with an investment that has a low IRR because of political pres- sures or to accomplish social objectives that lie outside the profit motive. The company might make a capital investment even if the numbers don’t justify the decision in order to fore- stall competitors from entering its market. Long-run capital investment decisions are at bottom really survival decisions. Y A company may have to make huge capital investments to FL upgrade, automate, or expand; if it doesn’t, it may languish and eventually die. AM AFTER-TAX COST-OF-CAPITAL RATE So far I have skirted around one issue in discussing dis- TE counted cash flow techniques for analyzing business capital investments—income tax. DCF analysis techniques were developed long before personal computer spreadsheet pro- grams became available. The DCF method had to come up with a way for dealing with the income tax factor, and it did, of course. The trick is to use an after-tax cost-of-capital rate and to separate the stream of returns from an investment and the depreciation deductions for income tax. An example is needed to demonstrate how to use the after- tax cost of capital rate. The cash registers investment exam- ined in the previous chapter is a perfect example for this purpose. To remind you, the retailer’s sources of capital and its cost of capital factors are as follows: Capital Structure and Cost-of-Capital Factors • 35 percent debt and 65 percent equity mix of capital sources • 8.0 percent annual interest rate on debt224
  • 231. DISCOUNTING INVESTMENT RETURNS EXPECTED• 40 percent income tax rate (combined federal and state)• 18.0 percent annual ROE objective The after-tax cost of capital rate for this business is calcu-lated as follows:After-Tax Cost-of-Capital RateDebt 35% × [(8.0%)(1 − 40% tax rate)] = 1.68%Equity [65% × 18.0%] = 11.70%After-tax cost-of-capital rate = 13.38% ROE is an after-tax rate; net income earned on the owners’ equity of a business is after income tax. Toput the interest rate on an after-tax basis, the interest rate ismultiplied by (1 − tax rate) because interest is deductible todetermine taxable income. The debt weight (35 percent in thisexample) is multiplied by the after-tax interest rate, and theequity weight (65 percent in this example) is multiplied by theafter-tax ROE rate. The after-tax cost of capital, therefore, is13.38 percent for the business. Recall that the entry cost of investing in the cash registersis $500,000. Assume that the future annual returns from thisinvestment are $172,463 for five years. Figure 14.3 in theprevious chapter shows that for this stream of future returnsthe company’s cost of capital requirements are satisfied exactly.Therefore, the present value of the investment must be exactly$500,000, which is the entry cost of the investment. Using theafter-tax cost-of-capital rate to discount the returns from theinvestment proves this point. As just calculated, the company’s after-tax cost-of-capitalrate is 13.38 percent. Instead of applying this discount ratedirectly to the $172,463 returns (labor cost savings) from theinvestment, the annual returns are first converted to an after-tax basis, as though the returns were fully taxable at the 40percent income tax rate. However, income tax is overstatedbecause the depreciation deduction based on the cost of theassets is ignored. The depreciation tax effect is brought intothe analysis as follows. In this example, the straight-line depreciation method isused, so the company deducts $100,000 depreciation eachyear for income tax purposes. This reduces its taxable income 225
  • 232. C A P I TA L I N V E S T M E N T A N A LY S I S and thus its income tax by $40,000 each year ($100,000 annual depreciation × 40% tax rate = $40,000 income tax sav- ings). The depreciation tax savings are added to the $103,478 after-tax returns each year, which gives a total of $143,478 for each year. These annual amounts are discounted using the after-tax cost-of-capital rate as follows: Present Value Calculations Year 1 $143,478 ÷ (1 + 13.38%)1 = $126,546 Year 2 $143,478 ÷ (1 + 13.38%)2 = $111,612 Year 3 $143,478 ÷ (1 + 13.38%)3 = $ 98,441 Year 4 $143,478 ÷ (1 + 13.38%)4 = $ 86,824 Year 5 $143,478 ÷ (1 + 13.38%)5 = $ 76,577 Present value = $500,000 The present value calculated in this manner equals the entry cost of the investment. (When the stream of future returns consists of uniform amounts, only one global calcula- tion is required, but I show them for each year to leave a clear trail regarding how present value is calculated.) The company would earn exactly its cost of capital, because the present value equals the entry cost of the investment. This point also is demonstrated in Figure 14.3 in the previous chapter. As I’ve said before, I favor a spreadsheet model for capital investment analysis over the equation-oriented DCF method. A spreadsheet model is more versatile and provides more information for management analysis. Also, I think it is a more intuitive and straightforward approach. REGARDING COST-OF-CAPITAL FACTORS Most discourses on business capital investment analysis assume a constant mix, or ratio, of debt and equity over the life of an investment. And the cost of each source of capital is held constant over the life of the investment. Also, the income tax rate is held constant. Before spreadsheets came along, there were very practical reasons for making these assumptions, mainly to avoid using more than one cost-of-capital rate in the analysis. Today these constraints are no longer necessary. If the situation calls for it, the manager should change the ratio of debt and equity from one period to the next or change226
  • 233. DISCOUNTING INVESTMENT RETURNS EXPECTEDthe interest rate and/or the ROE rate from period to period.Each period could be assigned its own cost-of-capital rate,in other words. Sometimes this is appropriate for particularcapital investments. For instance, a capital investment mayinvolve direct financing, in which a loan is arranged andtailor-made to fit the specific features of the investment. One example of direct financing is when a business offersits customers the alternative of leasing products instead ofbuying them. The business makes an investment in the assetsleased to its customers. The business borrows money to pro-vide part of the capital invested in the assets leased to cus-tomers. The leased assets are used as collateral for the loan,and the terms of the loan are designed to parallel the terms ofthe lease. Over the life of the lease, the mix of debt and equitycapital invested in the assets changes from period to period.Furthermore, the interest rate on the lease loan and the ROEgoal for lease investments very likely are different from thecost-of-capital factors for the company’s main line of business.sEND POINTThis and the previous chapter explain the analysis of a busi-ness’s long-term investments in operating assets. The capitalto make these investments comes from two basic sources—debt and owners’ equity. A business should carefully analyzecapital investments to determine whether the investment willyield sufficient operating profit to provide for its cost of capitalduring the life of the investment. This chapter demonstrateshow to use the spreadsheet model developed in the previouschapter for discounting the future returns from an investmentto determine its present value. The chapter also presents asuccinct survey of the commonly used mathematical tech-niques for analyzing business capital investments. Discounted cash flow is the broad generic name, orumbrella term, for the traditional equation-oriented capitalinvestment analysis methods. A stream of future cash returnsfrom an investment is discounted to calculate the presentvalue, or the net present value, of the investment. Alterna-tively, the internal rate of return that the future returns wouldyield is determined. The IRR of an investment is comparedagainst the company’s cost-of-capital rate and with the inter-nal rates of return of alternative investments. These mathe- 227
  • 234. C A P I TA L I N V E S T M E N T A N A LY S I S matical analysis techniques are explained in the chapter, while keeping the computational equations to a minimum. The equation-oriented techniques were developed before sophisticated spreadsheet programs were available for per- sonal computers. In my view, the spreadsheet model is a bet- ter analysis tool. Spreadsheets are more versatile, easier to follow, and make it possible to display all the relevant infor- mation for decision-making analysis and management con- trol. Nevertheless, the traditional capital investment analysis methods probably will be around for some time.228
  • 235. 5 PA R TEnd Topics
  • 236. 16 CHAPTERService BusinessesAAsk business consultants and I’d bet most would say that oneof the first things new clients tell them is: “Our business is dif-ferent.” Which is true, of course; every business is unique. Onthe other hand, all businesses draw on a common core of con-cepts, principles, and techniques. Take people: Every individ-ual is different and unique. Yet basic principles of behaviorand motivation apply to all of us. Take products: Breakfastcereals are different from computers, which are different fromautos, and so on. Yet basic principles of marketing apply to allproducts and services.Applying basic business concepts and principles is the difficultpart that managers are paid to do and do well. The managermust adapt the basic concepts and general principles to thespecific circumstances of her or his particular business. Like-wise, the tools and techniques of analysis demonstrated inprevious chapters must be adapted and modified to fit thecharacteristics and problems of each particular business. This chapter applies the profit analysis tools and tech-niques discussed in previous chapters to service businesses.These business entities do not sell a product, or if a product issold it is quite incidental to the service. There are very inter-esting differences in profit behavior between product andservice businesses. 231
  • 237. END TOPICS FINANCIAL STATEMENT DIFFERENCES OF SERVICE BUSINESSES Service businesses range from dry cleaners to film processors, from hotels to hospitals, from airlines to freight haulers, from CPAs to barbers, from rental firms to photocopying stores, from newspapers to television networks, and from movie theaters to amusement parks. The service sector is the largest general category in the economy—although extremely diverse. Nevertheless, a general example serves as a relevant framework for a large swath of service businesses. You can modify and tailor-fit this benchmark example to the particular characteristics of any service business. I use a typical example for a product-oriented company in Chapter 4 to demonstrate the interpretation of externally reported financial statements. Instead of introducing a new example, the product business example is converted to a service company example to point out the basic differences between these two types of business. Figure 16.1 presents the income statement and balance sheet (statement of financial condition) for the product business with certain accounts crossed out. You don’t find these accounts in the financial statements of a service company. A service company does not sell a product, so the inventories account and the inventory-dependent accounts are also crossed out. Accounts payable for inventories in the balance sheet is crossed out, but accounts payable for operating expenses remains. (In externally reported balance sheets, these two sources of accounts payable are blended into just one accounts payable liability account, but they are shown separately in Figure 16.1.) Minor differences in the statement of cash flows between product-based and service businesses are not shown in Figure 16.1. In the income statement, the cost-of-goods-sold expense account and the gross margin profit line are crossed out. Instead of cost of goods sold, most service businesses have comparatively larger fixed operating expenses relative to sales revenue than do product-based businesses. As just mentioned, service businesses have no inven- tories. In the example shown in Figure 16.1, inven-232
  • 238. SERVICE BUSINESSESIncome Statement for Year Just EndedSales revenue $39,661,250Cost of goods-sold-expense $24,960,750Gross margin $14,700,500Selling and administrative expenses $11,466,135Earnings before interest and income tax $ 3,234,365Interest expense $ 795,000Earnings before income tax $ 2,439,365Income tax expense $ 853,778Net income $ 1,585,587 Earnings per share $ 3.75Balance Sheet at Close of Year Just EndedAssetsCash $ 2,345,675Accounts receivable $ 3,813,582Inventories $ 5,760,173Prepaid expenses $ 822,899Total current assets $12,742,329Property, plant, and equipment $20,857,500Accumulated depreciation ($ 6,785,250)Cost less accumulated depreciation $14,072,250Total assets $26,814,579Liabilities and Owners’ EquityAccounts payable—inventories $ 1,920,058Accounts payable—operating expenses $ 617,174Accrued expenses payable $ 1,280,214Income tax payable $ 58,650Short-term debt $ 2,250,000Total current liabilities $ 6,126,096Long-term debt $ 7,500,000Total liabilities $13,626,096Capital stock (422,823 shares) $ 4,587,500Retained earnings $ 8,600,983Total Owners’ equity $13,188,483Total Liabilities and owners’ equity $26,814,579FIGURE 16.1 Items deleted for a service business (financial state-ments from Figures 4.1 and 4.2 for a product-based business). 233
  • 239. END TOPICS tories are almost $6 million, so if this were a service business its total assets would be $6 million less and its liabilities and owners’ equity would be $6 million less. Some service businesses (airlines, gas and electric utilities, railroads) make heavy investments in long-term, fixed operat- ing assets. These businesses are said to be capital-intensive. In the past, all three of these examples were regulated indus- tries, but more recently they have been deregulated. In con- trast, other types of service businesses (e.g., professional legal firms) make relatively light investments in fixed operating assets. Many service businesses are in the middle regarding capital invested in property, plant, and equipment. Examples are movie theater chains, newspapers, and book publishers. They invest in long-term operating assets, but not huge amounts. MANAGEMENT PROFIT REPORT FOR A SERVICE BUSINESS Y FL Figure 16.2 presents internal management reports for three profit modules of a service business, which are used through- AM out the rest of the chapter. You may notice that this example closely follows the three-profit module example for the prod- uct business in Chapter 9. My purpose is to provide compar- TE isons between a middle-of-the-road source of revenue with an average profit margin (the standard service in Figure 16.2), a no-frills basic service with a slim profit margin, and a top-of- the-line premier service with relatively high profit margin. Just as product-based businesses sell different products with different margins, many service businesses offer different services at different prices. For example, airline companies offer first class, standard class, and tourist class. Entertain- ment businesses charge different prices depending on where seats are located, as do football and baseball teams. Hotels charge different prices for rooms with a better view. And so on. Compared with the management profit reports in Figure 9.1 for the product business example, the major changes in Figure 16.2 are the absences of cost-of-goods-sold expense and gross margin. As mentioned earlier, service businesses don’t sell products and therefore they don’t have a cost-of- goods-sold expense or gross margin (sales revenue less cost of234
  • 240. SERVICE BUSINESSESStandard Service 100,000 units Per Unit TotalsSales revenue $100.00 $10,000,000Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000Unit-driven expenses $ 6.50 $ 650,000Contribution margin $ 85.00 $ 8,500,000Fixed operating expenses $ 75.00 $ 7,500,000Profit $ 10.00 $ 1,000,000Basic Service 150,000 units Per Unit TotalsSales revenue $ 75.00 $11,250,000Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000Unit-driven expenses $ 5.00 $ 750,000Contribution margin $ 67.00 $10,050,000Fixed operating expenses $ 60.33 $ 9,050,000Profit $ 6.67 $ 1,000,000Premier Service 50,000 units Per Unit TotalsSales revenue $150.00 $ 7,500,000Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500Unit-driven expenses $ 8.75 $ 437,500Contribution margin $130.00 $ 6,500,000Fixed operating expenses $110.00 $ 5,500,000Profit $ 20.00 $ 1,000,000FIGURE 16.2 Management profit reports for service business example.goods sold). Note that each service profit module earned $1million for the year just ended. The purpose of this is twofold. The three sources of sales added together provide $3 mil-lion profit, which is approximately equal to the earningsbefore interest and income tax shown in the income statementin Figure 16.1. The main reason for showing three different 235
  • 241. END TOPICS profit modules, however, is to contrast and compare the effects from changes in profit factors among the three. The amount of the cost-of-goods-sold expense amounts shown in Figure 9.1 for the product-based business are moved to fixed operating expenses in this example for the three service profit modules. In other words, the entire amount of the cost-of-goods-sold expense amount is moved down to the fixed operating expense account, which is the largest expense for each service line. Notice the relatively high amounts of fixed costs for each module in Figure 16.2. By definition, a service business sells services and not prod- ucts. Even so, incidental products are often sold along with the services. For example, a copying business (such as Kinko’s) sells paper to its customers. Of course, the main thing sold is the copying service, not the paper. Airlines sell trans- portation but also provide in-flight food and beverages. Hotels are not really in the business of selling towels and ashtrays, but they know that many guests take these with them on the way out. Many personal and professional service firms (e.g., CPA and architect firms) sell no product at all. (Although come to think of it, our architect charged us a small amount for blueprint copies of our home remodeling project.) Some expenses of a service business vary with total sales revenue. Credit card discounts and sales commissions come to mind. Service businesses also have some expenses that vary with sales volume—for example, the number of passengers flown by an airline. The number of hotel guests directly affects certain variable expenses of this business. Most service businesses are saddled with large annual fixed expenses. Service takes people to render it: Most service busi- nesses have a large number of employees on fixed salaries or who are paid fixed hourly rates based on a 40-hour work- week. Also, many service businesses, such as gas and electric utilities and airlines, make large capital investments in build- ings and equipment and record large depreciation expense each year. Therefore, the service business example includes a large amount of fixed expenses for each of the three profit modules. In contrast to product-based businesses, the contribution margins of service-based businesses are relatively large per-236
  • 242. SERVICE BUSINESSEScents of their sales revenue. For the service business exampleshown in Figure 16.1, the contribution margins are as follows: Standard service $85.00 unit margin ÷ $100.00 sales price = 85% Basic service $67.00 unit margin ÷ $75.00 sales price = 89% Premier service $130.00 unit margin ÷ $150.00 sales price = 87% The annual sales volumes in the three profit modules areexpressed in units of service, whatever these units might be—billable hours for a law firm, number of tickets for a movietheater, or passenger miles for an airline. For a long-distancetrucking company it is ton-miles hauled. Most service busi-nesses adopt a common denominator to measure their salesvolume activity.SALES PRICE AND VOLUME CHANGESThe profit impacts of increasing sales prices 10 percent versusincreasing sales volumes 10 percent are compared in Figure16.3. Please keep in mind that the baseline profit for each ofthe three profit modules is $1 million. The amount of the profitincrease is divided by $1 million to determine the percentageincreases shown in Figure 16.3. For all three service lines,note the relatively small difference in profit increase betweenthe sales volume and the sales price increase scenarios.Looking back at the profit effects for a product-based business(refer to Figure 10.2), there is a huge advantage to increasingsales price versus increasing sales volume by the same per-cent. But as Figure 16.3 shows, this is not true for a servicebusiness because price increases on top of the relatively highunit margins of a service business don’t pack the same wallopas price increases for a product business. For instance, consider the standard product line (Figure 9.1)versus the standard service line (Figure 16.2). In both, the salesprice is $100.00 per unit. The unit margin for the standardproduct line is $20.00 versus $85.00 for the standard serviceline. A 10 percent sales price increase yields a $9.15 unit mar-gin increase (net of revenue-driven variable expenses). This 237
  • 243. END TOPICS Standard Service Sales Volume Increase Sales Price Increase 110,000 units 100,000 units Per Unit Totals Per Unit Totals Sales revenue $100.00 $11,000,000 $110.00 $11,000,000 Revenue-driven expenses @ 8.5% $ 8.50 $ 935,000 $ 9.35 $ 935,000 Unit-driven expenses $ 6.50 $ 715,000 $ 6.50 $ 650,000 Contribution margin $ 85.00 $ 9,350,000 $ 94.15 $ 9,415,000 Fixed operating expenses $ 68.18 $ 7,500,000 $ 75.00 $ 7,500,000 Profit $ 16.82 $ 1,850,000 $ 19.15 $1,915,000 Profit increase (compared with Figure 16.2) 85% 92% Basic Service 165,000 units 150,000 units Per Unit Totals Per Unit Totals Sales revenue $ 75.00 $12,375,000 $ 82.50 $12,375,000 Revenue-driven expenses @ 4.0% $ 3.00 $ 495,000 $ 3.30 $ 495,000 Unit-driven expenses $ 5.00 $ 825,000 $ 5.00 $ 750,000 Contribution margin $ 67.00 $11,055,000 $ 74.20 $11,130,000 Fixed operating expenses $ 54.85 $ 9,050,000 $ 60.33 $ 9,050,000 Profit $ 12.15 $ 2,005,000 $ 13.87 $ 2,080,000 Profit increase (compared with Figure 16.2) 101% 108% Premier Service 55,000 units 50,000 units Per Unit Totals Per Unit Totals Sales revenue $150.00 $ 8,250,000 $165.00 $ 8,250,000 Revenue-driven expenses @ 7.5% $ 11.25 $ 618,750 $ 12.37 $ 618,750 Unit-driven expenses $ 8.75 $ 481,250 $ 8.75 $ 437,500 Contribution margin $130.00 $ 7,150,000 $143.88 $ 7,193,750 Fixed operating expenses $100.00 $ 5,500,000 $110.00 $ 5,500,000 Profit $ 30.00 $ 1,650,000 $ 33.88 $ 1,693,750 Profit increase (compared with Figure 16.2) 65% 69% FIGURE 16.3 Comparison of 10 percent increases in sales volume versus sales price.238
  • 244. SERVICE BUSINESSESequals a 46 percent leap in unit margin for the product busi-ness ($9.15 ÷ $20.00 = 46%), but only an 11 percent gain forthe service business ($9.15 ÷ $85.00 = 11%). For a service busi-ness, a price increase is better than a volume increase, but theadvantage is much less than for a product business. WHAT ABOUT FIXED COSTS? One key issue concerns the large amount of fixedoperating expenses for a typical service business. The profitincreases shown in Figure 16.3 are based on the premise thatfixed costs remain constant at the higher sales volumes. How-ever, if the business were already operating at or close to itscapacity limits, its fixed costs probably would have to beincreased to enable higher sales volumes. Keep in mind thatbasically fixed costs provide capacity, or the ability to handlea certain level of sales activity during the period. Capacity for a service business is measured by the totalnumber of hours its employee workforce could turn out duringthe year, the number of passenger miles that an airline couldfly, the number of energy units a utility could deliver over theperiod, and so on. Always a key question is whether capacityis being fully used or not. Some slack, or unused capacity, isnormal, which allows for a modest growth in sales volume.When sales volume is too far below capacity and top manage-ment sees no way to rebuild sales volume, the option is todownsize the capacity of the business. Looking at Figure 16.3 again, the business could affordto expand capacity and increase its fixed costs to support a10 percent gain in sales volume for its service lines—but notby more than the projected profit increase. Increasing salesprices generally does not require a business to increase itsfixed costs. So the clear advantage is on the side of increasingsales prices. Of course, the key question is whether a businesscould pass along a 10 percent sales price increase withoutadversely affecting the demand for its services.TRADE-OFF DECISIONSSuppose the business is considering cutting sales prices10 percent on all three of its service lines. One question the 239
  • 245. END TOPICS managers should ask is this: How much would the increases in sales volumes have to be simply to maintain the same profit? Of course, the business would really prefer to stimulate demand to increase profit, not just keep it the same. But cal- culating these same-profit sales volumes provides very useful points of reference. Each manager should forecast sales demand at the lower prices and compare the predicted sales volume against the same-profit volumes. The profit report format presented in Figure 16.4 is a good tool for this sort of analysis. (This is the same profit pathway used in Chapter 11 for analyzing trade-off decisions for a product-based business, except that cost-of-goods-sold expense is deleted.) Figure 16.5 shows the unit margins at the lower sales prices and the required sales volumes needed just to maintain the same profit. The required sales volumes are determined by dividing the contribution margin targets (from Figure 16.4) by the lower unit margins caused by the lower sales prices. Fixed costs are held the same, but as previously mentioned, one should be very careful in making this assumption when sales volumes are increased. What about the opposite trade-off ? Suppose sales prices were increased 10 percent, causing decreases in sales volume. The same method of analysis can be used to determine how far sales volume could drop and profit remain the same. (If you do these calculations the answers are standard = 9,719 units Service Line Standard Basic Premier Sales price $100.00 $75.00 $150.00 Revenue-driven expenses $8.50 $3.00 $11.25 Unit-driven expenses $6.50 $5.00 $8.75 Unit margin $85.00 $67.00 $130.00 Sales volume 100,000 150,000 50,000 Contribution margin $8,500,000 $10,050,000 $6,500,000 Fixed operating expenses $7,500,000 $9,050,000 $5,500,000 Profit $1,000,000 $1,000,000 $1,000,000 FIGURE 16.4 Profit model for a service business.240
  • 246. SERVICE BUSINESSES Service Line Standard Basic PremierSales price $90.00 $67.50 $135.00Revenue-driven expenses $7.65 $2.70 $10.12Unit-driven expenses $6.50 $5.00 $8.75Unit margin $75.85 $59.80 $116.13Contribution margin target $8,500,000 $10,050,000 $6,500,000Required sales volume 112,063 168,060 55,974Present sales volume 100,000 150,000 50,000Sales volume increase needed 12,063 18,060 5,974FIGURE 16.5 Sales volumes needed at 10 percent lower sales prices.decrease, basic = 14,555 units decrease, and premier = 4,822units decrease.) Whether a service business would willinglysacrifice sales volume and market share in order to increaseits sales prices is another matter.sEND POINTIn most ways, the financial statements of service businessesare not all that different from those of product companies(though there are some differences, of course). In a servicebusiness income statement, there is no cost-of-goods-soldexpense or gross margin. In a service business balance sheet,there are no inventories or accounts payable for inventories. Having said this, a service business may sell incidentalproducts with its services (popcorn and candy at a movietheater, for example) and therefore report a relatively smallamount of inventories. Some service businesses are verycapital-intensive (e.g., transportation companies, telephonecompanies, and gas and electricity utilities). Other servicecompanies need relatively little in the way of long-term oper-ating assets (e.g., CPAs and law firms). The tools of financial analysis are essentially the same forboth product and service businesses. Naturally the modelsand tools of analysis have to be adapted to fit the characteris-tics of each business. The chapter demonstrates techniques ofprofit analysis for service businesses. The profit consequences 241
  • 247. END TOPICS for a change in sales volume versus a change in sales price for service businesses are not nearly as divergent as those of product businesses. Sales price improvements have an edge over sales volume improvements for both types of businesses, but the advantage is not nearly so pronounced for service businesses. I should mention in closing that the ratios used for inter- preting profit performance and financial condition (Chapter 4) and the techniques for analyzing capital investments (Chap- ters 14 and 15) apply with equal force to service businesses and product businesses.242
  • 248. 17 CHAPTERManagement ControlMManagement decisions constitute a plan of action for accom-plishing a business’s objectives. Establishing the objectivesfor the period may be done through a formal budgetingprocess or without a budget. In either case, actually achiev-ing the objectives for the period requires management con-trol. In the broadest sense, management control refers toeverything managers do in moving the business toward itsobjectives. Decisions start things in motion; control bringsthings to a successful conclusion. Good decisions with badcontrol can turn out as disastrously as making bad decisionsin the first place. Good tools for making management deci-sions should be complemented by good tools for manage-ment control. Previous chapters concentrate on models of profit, cashflow, and capital investment that are useful in decision-making analysis. This chapter shifts attention to manage-ment control and explores how managers keep a steadyhand on the helm during the business’s financial voyage,often across troubled waters. This chapter also presents abrief overview of business budgeting. This short summaryon budgeting is not an exhaustive treatise on the topic, ofcourse. 243
  • 249. END TOPICS FOLLOW-THROUGH ON DECISIONS Management control is both preventive and positive in nature. Managers have to prevent, or at least minimize, wrong things from happening. Murphy’s Law is all too true; if something can go wrong, it will. Equally important, managers have to make sure right things are happening and happening on time. Managers shouldn’t simply react to problems; they should be proactive and push things along in the right direction. Man- agement control is characterized not just by the absence of problems, but also by the presence of actions to achieve the goals and objectives of the business. One of the best definitions of the management control process that I’ve heard was by a former student. I challenged the students in the class to give me a very good but very con- cise description of management control—one that captured the essence of management control in very few words. One Y student answered in two words: “Watching everything.” This pithy comment captures a great deal of what management FL control is all about. AM Management theorists include control in their conceptual scheme of the functions of managers, although there’s no consensus regarding the exact meaning of TE control. Most definitions of management control emphasize the need for feedback information on actual performance that is compared against goals and objectives for the purpose of detecting deviations and variances. Based on the feedback information, managers take corrective action to bring per- formance back on course. Management control is an information-dependent process, that’s for sure. Managers need actual performance informa- tion reported to them on a timely basis. In short, feedback information is the main ingredient for management control. And managers need this information quickly. Information received too late can result in costly delays before problems are corrected. MANAGEMENT CONTROL INFORMATION In general, management control information can be classified as one of three types:244
  • 250. MANAGEMENT CONTROL1. Regular periodic comprehensive coverage reports (e.g., financial statements to managers on the profit perform- ance, cash flows, financial condition of the business as a whole and major segments of the business)2. Regular periodic limited-scope reports that focus on criti- cal factors (e.g., bad-debt write-offs, inventory write- downs, sales returns, employee absenteeism, quality inspection reports, productivity reports, new customers)3. Ad hoc reports triggered by specific problems that have arisen unexpectedly, which are needed in addition to regu- lar control reports Feedback information divides naturally into either goodnews or bad news. Good news is when actual performance isgoing according to plan or better than plan. Management’s jobis to keep things moving in this direction. Management con-trol information usually reveals bad news as well—problemsthat have come up and unsatisfactory performance areas thatneed attention. Managers draw on a very broad range of informationsources to keep on top of things and to exercise control. Man-agers monitor customer satisfaction, employee absenteeismand morale, production schedules, quality control inspectionresults, and so on. Managers listen to customers’ complaints,shop the competition, and may even decide that industrialintelligence and espionage are necessary to get informationabout competitors. The accounting system of a business is oneof the most important sources of control information. Managers are concerned with problems that directlyimpact the financial performance of the business, of course—such as sales quotas not being met, sales prices discountedlower than predicted, product costs higher than expected,expenses running over budget, and cash flow running slowerthan planned. Or perhaps sales are over quota, sales pricesare higher than predicted, and product costs are lower thanexpected. Even when things are moving along very close toplan, managers need control reports to inform them of con-formity with the plan. Control reports should be designed to fit the specific areas of authority and responsibility of individualmanagers. The purchasing (procurement) manager gets control 245
  • 251. END TOPICS reports on inventory and suppliers; the credit manager gets control reports on accounts receivable and customers’ payment histories; the sales manager gets control reports on sales by product categories and salespersons, and so on. Periodic control reports are rich in detail. For example, the monthly sales report for a territory may include breakdowns on hundreds and perhaps more than a thousand different products and customers. Moving up in the organization to a brand manager or a division manager, for example, the span of management authority and responsibility becomes broader and broader. At the top level (president or chief executive offi- cer), the span of authority and responsibility encompasses the whole business. At the higher rungs on the organizational lad- der, managers need control information in the form of com- prehensive financial and other reports. Financial statements for management control are much more detailed and are supplemented by many supporting schedules and analyses compared with the profit and cash flow models explained in earlier chapters, which are used pri- marily for decision-making analysis. For instance, manage- ment control financial reports include detailed schedules of customers’ receivables that are past due, products that have been held in inventory too long, lists of products that have unusually high rates of return from customers (probably indi- cating product defects), particular expenses that are out of control relative to the previous period or the goals for the cur- rent period, and so on. The profit and cash flow models illus- trated in earlier chapters are like executive summaries compared with the enormous amount of detail in manage- ment control reports. In addition to comprehensive control reports, a manager may select one or several specific factors, or key items, for special attention. I read about an example of this approach a couple of years ago. During a cost-cutting drive, the chief executive of a business asked for a daily count on the number of company employees. He was told he couldn’t get it. Some data kept by divisions were difficult to gather together in one place. Some were in a payroll database accessible only to programmers. But the CEO persisted, and now the data are at his fingertips whenever he wants them: A specially designed executive246
  • 252. MANAGEMENT CONTROLinformation system links personnel data directly to a personalcomputer in his office. “Management knows I’m watching thecount very closely,” he said. “Believe me, they don’t add staffcarelessly.” It’s a good idea to identify a few relatively critical successfactors and keep a close watch on them. Knowing what thesefactors are is one secret of good management. Product qualityis almost always one such key success factor. Customer loyaltyis another. By their very nature, management control reports are con-fidential and are not discussed outside the company. Manage-ment control reports contain very sensitive information; thesereports disclose the “mistakes” of decisions that went wrong. Often, unexpected and unpredictable developments upsetthe apple cart of good decisions. Some degree of inherentuncertainty surrounds all business decisions, of course. Never-theless, management control reports do have a strong elementof passing judgment on managers’ decisions and their abilityto make good predictions. INTERNAL ACCOUNTING CONTROLS A business relies heavily on its accounting system to supply essential information for management con-trol. The reliability of accounting information depends heavilyon specially designed procedures called internal accountingcontrols and how well these controls are working in actualpractice.Forms and ProceduresSpecific forms are required to carry out the activities of thebusiness, and certain established procedures must be fol-lowed. One fundamental purpose of these forms and proce-dures is to eliminate (or at least minimize) data processingerrors in capturing, processing, storing, retrieving, andreporting the large amount of information needed to operate abusiness. Forms and procedures are not too popular, but without theman organization couldn’t function. Without well-designed formsand clear-cut procedures for doing things, an organization 247
  • 253. END TOPICS couldn’t function very well, if at all. On the other side of the coin, there’s a danger that filling out the forms becomes per- functory and careless, and some employees may bypass them or take shortcuts instead of faithfully following official procedures. Internal accounting controls also are instituted for anotherDANGER! extremely important reason—to protect against theft and fraud by employees, suppliers, customers, and managers themselves. Unfortunately, my father-in-law was right. He told me many years ago that, based on his experience, “There’s a little bit of larceny in everyone’s heart.” He could have added that there’s a lot of larceny in the hearts of a few. It’s an unpleasant fact of business life that some customers will shoplift, some vendors and suppliers will overcharge or short-count on deliveries, some employees will embezzle or steal assets, and some managers will commit fraud against the business or take personal advantage of their position of authority. Newspapers and the financial press report stories of employee and management fraud with alarming frequency. In summary, internal controls have two primary pur- poses: (1) to ensure the accuracy, completeness, and timeliness of information collected, processed, and reported by the accounting system, and (2) to deter and detect dishon- est, illegal, and other behaviors counter to the policies of the business by its employees, managers, customers, and others. This is a tall order, but any business manager you ask about this will attest to the need for effective internal accounting controls. The ideal internal accounting control is one that ensures the integrity of the information being recorded and processed, one that deters or at least quickly detects any fraud and dis- honesty, and one that is cost-effective. Some controls are sim- ply too costly or are too intrusive on personal privacy. Body searches of employees leaving work might qualify, though dia- mond and gold mines take these precautions, I understand, and a recent article in the New York Times indicated that some of General Electric’s employees must go through a search on exiting from work.248
  • 254. MANAGEMENT CONTROLINDEPENDENT AUDITS AND INTERNAL AUDITINGThe national organization of CPAs, the American Institute ofCertified Public Accountants (AICPA), is a good source for use-ful publications that deal with internal accounting controls.*These are superb summaries and reflect the long experienceof CPAs in auditing a wide range of businesses. The AICPA’sguidelines are an excellent checklist for the types of internalaccounting controls that a business should establish andenforce with due diligence. Speaking of CPAs, financial statement audits by inde- pendent public accountants can be viewed as one typeof internal control. Based on its annual audit, the CPA firmexpresses an opinion on the external financial statementsissued by a business. Business managers should understandthe limits of audits by CPAs regarding the discovery of errorsand fraud. Auditors are responsible for discovering materialerrors and fraud that would cause the financial statements tobe misleading. However, it is not cost-effective to have the out-side auditor firm do a thoroughgoing examination that wouldcatch all errors and fraud. It would take too long and cost toomuch. The first line of defense is the business’s internalaccounting controls. Having an audit by an independent CPAfirm provides an independent appraisal and check on its inter-nal controls, but the business itself has the primary responsibil-ity to design and establish effective internal accounting controls. Many larger business organizations establish an internalauditing function in the organization structure of the business.Although the internal auditors are employees of the organiza-tion, they are given autonomy to act independently. Internalauditors report to the highest levels of management, oftendirectly to the board of directors of the corporation. Internalauditors monitor and test the organization’s internal accounting*A good place to start is Statement on Auditing Standards No. 55, “Consid-eration of the Internal Control Structure in a Financial Statement Audit”(American Institute of Certified Public Accountants, Inc., New York, origi-nally issued in 1988 and later amended). Also, the AICPA has put out anAudit Guide on this topic, and the Committee of Sponsoring Organizationsof the Treadway Commission issued a series of influential publications deal-ing with internal control in 1992. 249
  • 255. END TOPICS controls regularly. They also carry out special investigations, either on their own or at the request of top management and the board of directors. Different departments and areas of operation are audited on a surprise basis or on a regular rota- tion basis.DANGER! FRAUD Business fraud is like adultery. It shouldn’t happen, but those who do it make every attempt to hide it, although it often comes out eventually. The same holds true for business fraud. Businesses handle a lot of money, have many valuable assets, and give managers and other employees a great deal of authority. So it’s not surprising that a business is vulnerable to fraud and other dishonest schemes. Fraud, in contrast to theft, involves an element of deception. The guilty person is in a position of trust and authority. The perpetrator of fraud owes a duty to his or her employer, but deliberately violates this duty and covers up the scheme. Many books have been written on business fraud. Many seminars and training programs are offered that deal with fraud in the business world. Indeed, developments are under way to make the control and detection of business fraud a professional specialty. Keep in mind that audits and internal accounting controls are not foolproof. A disturbing amount of fraud still slips through these preventive measures. High-level management fraud is particularly difficult to prevent and detect. By their very nature, high-level managers have a great deal of authority and discretion. Their positions of trust and power give high-level managers an unparalleled opportunity to commit fraud and the means to conceal it. A few years ago several investment banks and other financial institutions revealed huge losses caused by employees making unauthorized trades in financial derivatives. In virtually all of these cases there was a breakdown in important internal con- trols. Many of these cases violated one of the most important of all internal controls—requiring two or more persons to authorize significant expenditures and major risk exposures. Many of these cases also revealed another key internal control that was violated: separation of duties. The authority for mak- ing a decision and carrying it out should always be separated250
  • 256. MANAGEMENT CONTROLfrom its accounting and record keeping functions. One personshould never do both. One prime example of a high-risk fraud area in businesscomes to mind. The purchasing agents of a business are vul-nerable to accepting bribes, kickbacks, under-the-table pay-ments, and other favors from vendors. A purchasing agent Iknow very well made me aware of how serious a problem thisis. He didn’t say that all purchasing agents are corrupt, but hecertainly suggested that the temptation is there and that manysuccumb.Keeping a close watch on cash flows is a good way to catchsigns of possible fraud, which is evidently overlooked by mostmanagers. Most fraud schemes and scams go after the money.As Willie Sutton said when asked why he robbed banks,“Because that’s where the money is.” To get the money andconceal the fraud as long as possible, a perpetrator mustmanipulate and misstate an asset or a liability—most oftenaccounts receivable, inventories, or sometimes accountspayable. (Other assets and liabilities may also be involved.) In particular, managers should keep alert to increases inaccounts receivable and inventories. Not only do theseincreases cause negative cash flow effects, such increasescould signal a suspicious change that is not consistent withchanges in sales activity and other facts and informationknown to the manager. It may be argued that businesses should aggressively prose-cute offenders. The record shows, however, that most busi-nesses are reluctant to do this, fearing the adverse publicitysurrounding legal proceedings. Many businesses adopt the pol-icy that fraud is just one of the many costs of doing business.They don’t encourage it, of course, and they do everythingpractical to prevent it. But in the final analysis, a majority ofbusinesses appear to tolerate some amount of normal lossfrom fraud. As an example, suppose an employee or midlevel managersteals inventory and sells the products for cash, which goesinto his or her pocket. A good management control reportingsystem keeps a very close watch on inventory levels and cost-of-goods-sold expense ratios. If a material amount of inven-tory is stolen, the inventory shrinkage and/or profit marginfigures should sound alarms. The sophisticated thief realizes 251
  • 257. END TOPICS this and will cover up the missing inventory. Indeed, this is exactly what is done in many fraud cases. In one example, a company’s internal controls were not effec- tive in preventing the coverup; the accounting system reported inventory that in fact was not there. Thus, inventory showed a larger increase (or a smaller decrease) than it should have. You might think that managers would be alert to any inventory increase. But in the majority of fraud cases, managers have not pursued the reasons for the inventory increase. If they had, they might have discovered the inventory theft. In similar fashion, fraud may involve taking money out of collections on accounts receivable, which is covered up by overstating the accounts receivable account. Other fraud schemes may use accounts payable to conceal the fraud. Managers should keep in mind that the reported profit per- formance of the business will be overstated as the result of undiscovered fraud. This is terribly embarrassing when it is discovered and prior financial statements have to be revised and restated. But fraud can be disastrous. Furthermore, it may lead to firing the executive who failed to discover the theft or fraud; one responsibility of managers is to prevent fraud by subordinates and to devise ways and means of ensuring that no fraud is going on. MANAGEMENT CONTROL REPORTING GUIDELINES The design of effective and efficient management control reports is a real challenge. This section presents guidelines and suggestions for management control reporting. Unfortu- nately, there is no one best format and system for control reporting. There is no one-size-fits-all approach for communi- cating the vital control information needed by managers, no more than there are simple answers in most areas of business decision making. One job of managers is to know what they need to know, and this includes the information they should get in their control reports. Control Reports and Making Decisions The first rule for designing management control reports is that they should be based on the decision-making analysis252
  • 258. MANAGEMENT CONTROLmethods and models used by managers. This may soundstraightforward, but it’s not nearly as easy as it sounds. Thisfirst rule for control reports is implicit in the concept of feed-back information discussed at the beginning of the chapter.One problem is that control reports include a great deal ofdetail, whereas the profit and cash flow models that are bestfor decision-making analysis are condensed and concise. Nevertheless, control reports should resonate as much aspossible with the logic and format of the models used bymanagers in their decision-making analysis. For example, thereports each period on the actual results of a capital invest-ment decision should be structured the same as the man-ager’s capital investment analysis. If the manager uses thelayout shown in Figures 14.2 and 14.3, for instance, then thecontrol report should be in the same format and include com-parison of actual returns with the forecast returns from theinvestment.Need for Comparative ReportsMore than anything else, management control is directedtoward achieving profit goals and meeting the other financialobjectives of the business. Goals and objectives are not estab-lished in a vacuum. Prior-period performance is one referencefor comparison, of course. Ideally, however, the businessshould adopt goals and objectives for the period that are putinto a framework of clear-cut benchmarks and standardsagainst which actual performance is compared. Budgeting,discussed later in the chapter, is one way of doing this. In practice, many companies simply compare actual per-formance for the current period against the previous period.This is certainly better than no comparison at all, and it doesfocus attention on trends, especially if several past periodsare used for comparison and not just the most recent period.However, this approach may sidetrack one of management’smain responsibilities, which is to look ahead and forecastchanges in the economic environment that will affect thebusiness. Changes from previous period may have been predictableand should have been built into the plan for the currentperiod. The changes between the current period and the pre-vious period don’t really present any new information relative 253
  • 259. END TOPICS to what should have been predicted. The manager should get into a forward-planning mode. Based on forecasts of broad average changes for the coming period, profit and cash flows budgets are developed, which serve as the foundation for planning the capital needs of the business during the coming period. One danger of using the previous period for compari- son is that the manager gets into a rear-view style of manage- ment—looking behind but not ahead. Management by Exception One key concept of management control reporting is referred to as management by exception. Managers have limited time to spend on control reports and therefore they focus mainly on deviations and variances from the plan (or budget). Departures and detours from the plan are called Y exceptions. The premise is that most things should be going according to plan but some things will not. Managers need to FL pay the most attention to the things going wrong and the things that are off course. AM Frequency of Control Reports A tough question to answer is how frequently to prepare con- TE trol reports for managers. They cannot wait until the end of the year for control reports, of course, although a broad-based and overall year-end review is a good idea to serve as the platform for developing next year’s plan. Daily or weekly con- trol reports are not practical for most businesses, although some companies, such as airlines and banks, monitor sales volume and other vital operating statistics on a day-to-day basis. Monthly or quarterly management control reports are the most common. Each business develops its own practical solu- tion to the frequency question; there’s no single general answer that fits all companies. The main thing is to strike a balance between preparing control reports too frequently ver- sus too seldom. With computers and other electronic means of communication today, it is tempting to bombard managers with too much control information too often. Sorting out the254
  • 260. MANAGEMENT CONTROLtruly relevant from the less relevant and truly irrelevant infor-mation is at the core of the manager’s job.Profit Control ReportsThe type of management profit report illustrated in previouschapters is a logical starting point for designing reports tomanagers for profit control. First and foremost, profit marginsand total contribution margin should be the main focus ofattention and should be clear and easy to follow. These twokey measures of performance should be reported for eachmajor product or product line (backed up with detailed sched-ules for virtually every individual product) in managementprofit performance reports. These are very confidential data,which are not divulged in external income statements—or, forthat matter, very widely within the business organization. Variable expenses should be divided between those that depend on sales volume and those that dependon sales revenue and broken down into a large number ofspecific accounts. Sales volumes for each product and productline should be reported. Fixed expenses should be brokendown into major components—salaries, advertising, occu-pancy costs, and so on. Sales and/or manufacturing capacityshould be reported. Any significant change in capacity due tochanges in fixed expenses should be reported. Management control reports should analyze changes inprofit. In particular, the impact of sales volume changesshould be separated from changes in sales price, product cost,and variable expenses as explained in earlier chapters (seeChapters 9 and 10). If trade-off decisions were made—forexample, cutting sales price to increase sales volume—thereshould be follow-up analysis in the management control profitreports that track how the decision actually worked out. Didsales volume increase as much as expected? As this chapter explains later in more detail, a fringe ofnegative factors constantly threaten profit margins and bloatfixed expenses. Each of these negative factors should be sin-gled out for special attention in management profit controlreports. Inventory shrinkage, for example, should be reportedon a separate line, as should sales returns, unusually high bad 255
  • 261. END TOPICS debts, and any extraordinary losses or gains recorded in the period (with adequate explanations). If there is a general fault with internal profit reports for man- agement control purposes, it is in my opinion the failure of the accounting staff to explain and analyze why profit increased or decreased relative to the previous period or relative to the budget for the period. Such profit-change analysis would be very useful to include in the profit reports. But managers gen- erally are left on their own to do this. The analysis tools dis- cussed in previous chapters are very helpful for this. Sales Price Negatives When eating in a restaurant, you don’t argue about the menu prices. And you don’t bargain over the posted prices at the gas pump or in the supermarket. In contrast, sales price nego- tiation is a way of life in many industries. Many businesses advertise or publish list prices. Examples are sticker prices on new cars, manufacturer’s suggested retail prices on consumer products, and standard price sheets for industrial products. List prices are not the final prices; they are only the point of reference for negotiating the final terms of the sale. In some cases, such as new car sales, neither the seller nor the buyer takes the list price as the real price—the list price simply sets the stage for bargaining. In other cases, the buyer agrees to pay list price, but demands other types of price concessions and reductions or other special accommodations. Prompt-payment discounts are offered when one business sells to another business on credit. For example a 2 percent discount may be given for payment received within 10 days after the sales invoice date. These are called sales discounts. Buyers should view these as penalties for delayed payment. Also, businesses commonly give their customers quantity dis- counts for large orders, and most businesses offer special discounts in making sales to government agencies and educa- tional institutions. Many consumer product companies offer their customers rebates and coupons, which lower the final net sales price received by the seller, of course. Businesses also make allowances or adjustments to sales prices after the point of sale when customers complain about the quality of the256
  • 262. MANAGEMENT CONTROLproduct or discover minor product flaws after taking delivery.Instead of having the customer return the product, the com-pany reduces the original sales price.Managers must decide how these sales price negatives shouldbe handled in their internal management control reports. Onealternative is to report sales revenue net of all such salesprice reductions. I don’t recommend this method. The betterapproach is to report sales revenue at established list prices.All sales price negatives should be recorded in sales revenuecontra accounts that are deducted from gross (list price) salesrevenue. Figure 17.1 illustrates the reporting sales price negatives tomanagers. Seven different reductions from sales revenue areshown in this figure. A business may not have all the salescontra accounts shown, but three or four are not unusual. Theamounts of each contra account may not be as large as shown(hopefully not). In the external income statement of the business, only netsales revenue ($8,303,000 in Figure 17.1) is reported, as ageneral rule. For internal management control reporting,however, gross (list price) sales revenue before all sales pricereductions should be reported to give managers the completerange of information they need for controlling sales prices.Sales price negatives should be accumulated in contra (deduc-tion) accounts so that managers can monitor each one relative Gross sales revenue, at list prices $10,000,000 Sales price negatives: Sales price discounts—normal ($150,000) Sales price discounts—special ($200,000) Sales returns ($175,000) Quantity discounts ($275,000) Rebates ($650,000) Coupons ($165,000) Sales price allowances ($ 82,000) ($ 1,697,000) Net sales revenue $ 8,303,000 FIGURE 17.1 Sales revenue negatives in a management control report. 257
  • 263. END TOPICS to established sales pricing policies and so they can make comparisons with previous periods and with the goals (or budget) for the current period. Inventory Shrinkage Inventory shrinkage is a serious problem for many busi-DANGER! nesses, especially retailers. These inventory losses are due to shoplifting by customers, employee theft, and short counting from suppliers. Many businesses also suffer inven- tory obsolescence, which means they end up with some prod- ucts that cannot be sold or have to be sold below cost. When this becomes apparent, inventory should be decreased by write-down entries. The inventories asset account is decreased and an expense account is increased. Losses caused by damage to and deterioration of products being held in inventory and inventory write-downs to recog- nize product obsolescence should be separated from losses due to theft and dishonesty—but sometimes the term inven- tory shrinkage is used to include any type of inventory disap- pearance and loss. Inventory shrinkage of 1.5 to 2.0 percent of retail sales is not unusual. Inventory loss due to theft is a particularly frustrating expense. The business buys (or manufactures) products and then holds them in inventory, which entails carrying costs, only to have them stolen by customers or employees. On the other hand, inventory shrinkage due to damage from handling and storing products, product deterioration over time, and product obsolescence is a normal and inescapable economic risk of doing business. Internal management control reports definitely should sepa- rate inventory shrinkage expense and not include it in the cost-of-goods-sold expense. Inventory shrinkage is virtually never reported as a separate expense in external income statements; it is combined with cost-of-goods-sold or some other expense. However, managers need to keep a close watch on inventory shrinkage, and they cannot do so if it is buried in the larger cost-of-goods-sold expense. Another reason for separating inventory shrinkage in man- agement control reports is that this expense does not behave the same way as cost-of-goods-sold expense. Cost-of-goods-258
  • 264. MANAGEMENT CONTROLsold expense varies with sales volume. Inventory shrinkagemay include both a fixed amount that is more or less the sameregardless of sales volume and an amount that may vary withsales volume. Strong internal controls help minimize inventory shrinkage.But even elaborate and expensive inventory controls do noteliminate inventory shrinkage. Almost every business toleratessome amount of inventory shrinkage. For instance, most busi-nesses look the other way when it comes to minor employeetheft; they don’t encourage it, of course, but they don’t do any-thing about it, either. Preventing all inventory theft would betoo costly or might offend innocent customers and hurt salesvolume. Would you shop in retail stores that carried out bodysearches on all customers leaving the store? I doubt it. Manyretailers even hesitate to require customers to check bagsbefore entering their stores. On the other hand, closed-circuitTV monitors are common in many stores. Retailers are con-stantly trying to find controls that do not offend their cus-tomers. As you know, product packages are often designed tomake it difficult to shoplift (e.g., oversized packages that aredifficult to conceal). In internal management control reports, the negative fac-tors just discussed should be set out in separate expenseaccounts if they are relatively material or listed separately in asupplementary schedule. Managers may have to specificallyinstruct their accountants to isolate these expenses. In exter-nal income statements, these costs are grouped in a largerexpense account (e.g., cost of goods sold, general and admin-istrative expenses).Sales Volume NegativesSales returns can be a problem, although this varies fromindustry to industry quite a bit. Many retailers accept salesreturns without hesitation as part of their overall marketingstrategy. Customers may be refunded their money, or theymay exchange for a different product. On the other hand,products such as new cars are seldom returned (even whenrecalled).Sales returns definitely should be accumulated in a separatesales contra account that is deducted from gross sales revenue 259
  • 265. END TOPICS (see Figure 17.1 again). The total of sales returns is very importa